# what does cap rate mean?

- I am filling out the for sale form om loop .net. It asks for CAP RATE i do not know this term.
- In Selling Property - Asked by craig c. - Jan 28, 2011

#### Answer(s)

There are many cap rates (capitalization rates).

A commonly used capitalization for the direct capitalization process is a composite rate developed directly from the market. It is used for converting property income into value. When you are analyzing sales, take the net income and divide by the sale price.

The variety and usefulness of this tool is endless.

Cap Rate, or capitalization rate, is the ratio of the amount of money a property is producing to the purchase price of the property. Simply put, it is the Net Operating Income (NOI) of the property divided by the purchase price.

Cap Rate is a good snapshot indicator to see if the purchase price is in line with income and comparable properties, but it doesn't tell the whole story.

It is short for capitalization rate. It is the rate of return the property will produce on the investment. It is the net operating income for the year divided by the purchase price. It is shown in the percent form.

There is a lot of variance in how the term "Cap Rate" is used. I would recommend asking for a profit and loss statement, running estimated expenses on it yourself and then determining the cap rate from that basis. Many listings show a cap rate based on pro forma income and expenses. What you want are realistic numbers, which many times are between actual and pro-forma, but the best buys usually have cap rates based on actuals. Make sure their analysis includes management costs, adjusted tax rates based on the levy at the price you intend to purchase at and then also account for vacancy factors, and normal repairs in a year. A common tactic is to do very little maintenance the year before the sale so the cap rate looks better than the previous years. Always ask for 3 years of performance if it can be provided. I like the cap rate as a quick napkin test, but prefer Discounted Cash Flow analysis for my own investors. The IRR (internal rate of return) while not perfect and has a lot more room for erroneous assumption, if done conservatively can provide a good anticipation of what to expect.

The Capitalization Rate (CAP) is a Financial Formula that defines the actual percentage of the Net Operating Income (NOI) to the Sale/Purchase Price. This is a very important Financial Analysis Tool because a Buyer, or an Investor can see how long it will take him/her to Pay-Off his Investment. For Example, a Property that has $3,000,000 NOI, and is being sold for $30,000,000, then the property has a 10% CAP Rate, or it will take 10 years +/- to Pay-Off that property. A better way is to find what is the Property Value by by dividing the NOI by the Desired CAP Rate. Fore Example, the Property Value will be different each time a Different CAP Rate is used. Dividing $3,000,000 NOI by a 5% CAP Rate, makes the Property Value $60,000,000, while dividing a $3,000,000 NOI by a 10% CAP Rate, will make the Property Value $30,000,000. In sum, Buyers & Investors are looking for higher CAP Rate because they will Pay-Off their Property in a shorter time, and will have a high Return in the Investment.

Craig.... All the previous answers are correct. Understanding cap rate usage in the commercial real estate business is essential. As one of the respondents pointed out cap rate usage in analysis has many forms. For example, if someone were offering a property at a 6% cap rate on verifiable at a minimum one year past annual net operating income (NOI) of $100,000, the asking price would be $1,666,667, If your client is looking for a return of 7% on his capital (assuming a non-financed property), your purchase price for the LOI would be $1,428,571. As a word of advice, if this sounds at all confusing, do not be flustered. Understanding and using cap rates in your commercial real estate practice will become very clear with the right mentor. Good luck Craig..... Rob Baird, CA RE License #544165 (One of the oldest, active licenses in CA) 951 515-5855 Email: rob@capratecommercial.com

The problem with CAP rate is the net operating income does not take into account any financing cost. So if a property was bought for $1000.00 and the rent is $800.00 you have a cap rate of (800/1000)*100 expressed as percentage i.e. 8%.

CAP RATE is the formula: NET OPERATING INCOME divided by the PRICE PAID for the Investment. Specific market rates are compared to the rate for a particular property thereby determining how that property at that price measures up.

CASH ON CASH is smartly used to determine the rate of return on the down payment for a property. Formula: NET INCOME; after expenses and debt service; divided by the CASH INVESTED. Used with the CAP RATE, this gives an investor a way to understand what return they will receive from the investment verses a CD or other money market returns.

in laymen's terms it is the rate of return a reasonable investor would expect to receive on an investment. It works like a bond in that the higher the cap rate (interest rate on bond), the lower the value. Cap rates are market and property specific

What the LoopNet Query is asking is the ratio of income to price, without considering debt, depreciation or tax.

The net operating income divided by your asking price = Cap Rate. This is a "going-in" Rate.

Net Operating Income is pre-tax (no depreciation, no mortgage interest) and pre-debt service (no mortgage payement - all cash).

All the answers are good. However, what determines the rate is the market and risk associated to the property. Each investor has their own risk tolerance and investment return factor. Lower the cap rate = less risk and higher the cap rate = higher risk

The Cap Rate as defined in these answers only tells part of the story that an investor needs. A carefully calculated Cap Rate is a reasonable way to arrive at the actual value of a property (don't forget to include a reserve allocation for major replaceables such as roof and HVAC). Once you arrive at a Cap Rate, you can then model financing scenarios against the result in order to determine loan-to-value and debt-to-equity ratios. When an acceptable lending scenario is achieved, you'll be able to calculate the Equity Dividend Ratio (known as "cans-on-cash) and thereby predict the earnings that an investor might anticipate on the actual cash that will be invested.

The ”OAR” is an abbreviation of “Overall Rate”. It is an income capitalization rate that reflects the relationship between a 12 month Net Operating Income and the total value of the property. The OAR for a particular property is a subjective number that is very much influenced by the market. For example, a particular city might have a 9% OAR rate, while another one might have a 7% OAR rate. Frankly, the nature of real estate is such that those differences can be found between neighborhoods within a city only a few blocks apart. In arriving at a credible Cap Rate, along with documented resources, the appraiser must take in to account the location, economy and the measurability of the risk of the investment, ranging from, low, medium, to high risk. OAR rates are never cut in stone. We as appraisers must pay particlar attention to what's going on in a particular neighborhood because if the neighborhood of the subject appears to have a cap rate of 8% at the time of the report but the neighborhood appears as if it's on a decline, in my humble opinion, the cap rate numbers from the data bases that are used are inferior to the appraiser's knowledge. It's always a great idea to do some research about what's going on within a 3 miles radius of where your subject is. We need to talk to local real estate agents, brokers, and investors. Also, what's going on in the residential market has an impact on the commercial cap rates as well. There is so much more to a cap rate than meets the eye. Hope this helps.

Simply put. If an investment throws off an income of $10, and my desire return is 10%, how much am I willing to pay for that investment. The answer is $100. That is a CAP rate of 10. So if you have a building that throws off $100,000 of NOI (revenue minus operating expenses, but not debt service) and you want no less than a 10% return, you pay no more than $1 million for it. Therefore, the CAP rate has an inverse relationship with the purchase price. The higher the CAP rate, the lower the price. The opposite is true.

The CAP rate should be a personal thing. You look at your alternative investment opportunities at a particuler time. If the banks are offering 1% return on your deposits and you can get a 6% return (6 CAP), that may be a decent investment. But you must assess the risk of investing in real estate instead of an FDIC insured deposit. On the other hand, if a AAA corporate bond is returning 6%, then a riskier RE investment may require a higher return say may be 10 CAP (10%) or higher ?

So CAP rate should be a very personal investment tool because everyone has a different investment strategy. Unfortunately, most people have no clue what it means, including most of the brokers and bankers. As a result, everyone is walking around quoting CAP rate, CAP rate thill their face sturn blue. What people are doing is quoting CAP rates as a comparable...an indication of what the going rate is among commercial estate buyers and sellers.

Somebody said earlier that CAP rates only tell part of the story because it does not address debt service and he is absolutely right. To make things worse, in the last few uears, people, especially the borkers, have been using CAP rate as a comparable sales tool, giving no consideration to cash flow and IRR. As a result, CAP rates has been driven lower and lower to 3 and 4 CAP, meaning prices have gone higher and higher with no regard to profitability. The most frequent comment I heard was,"well that is the going CAP rate". Thus the commercial real estate market went the way of the residential real estate market which uses comparable sales approach only...and we know what happened there.

So ask yourself a question, as an investor, are you willing to march up the hill with everyone else and line up at the cliff to take a giant leap of faith just because someone else wants to commit suicide? or are you going to look at your personal investment strategy, given all the investment options , and assess the risk you can afford to take?

Having said that, do look at CAP rates when you sell because you want to know what people are paying but never use CAP rate as a benchmark to buy. Do use IRR or a simple % of cash on cash return but pay attention to you debt service coverage ratio (NOI divided by debt service). You want a healthy DSC of at least 1.3 because it tells you whether you can pay your mortgage or not.

The market and lenders usually have an expectation of a Cap Rate for a class of investment. For instance, a Class B Apartments may be valued at a 6% Cap Rate in the current market conditions. Cap Rates are a guide and are dynamic with the market performance. Fundamentally, they are a function of expected inflation, the real rate of interest, and investor cost of capital. A handy formula to remember is "our old friend IRV" where Income=Return x Value and Value=Income/Return. (I=Net Operating Income, R=Cap Rate, & V=the value of the property)

Part of my blogs purpose is to provide clear and concise commercial real estate education. Here's my answer to this question from about a month ago on my blog:

Capitilization rates, or cap rates, are a way to get an understanding of a commercial property's value. Put simply, the cap rate is the rate at which the property makes money. For instance, if a $100 property made $10 per year, the cap rate would be 10%.

Inverse relationship: Here's a FREE bonus definition for you today! An inverse relationship is when two values move in opposite direction in relation to each other. A playground teeter totter is an example of an inverse relationship. When Jack and Jill teeter totter, when Jack goes up, Jill goes down. Inversly, when Jack goes down, Jill goes up. Nothing to this stuff, right?

Cap rates have an inverse relationship with the value of the property. As the cap rate goes up, the value of the property goes down. Our example property above had a cap rate of 10% because it made $10 on a $100 property. If we lower the cap rate to 6%* the value of the property goes up to $166. If we were to raise the cap rate to 12% the value of the property would go down to $83.

For Kansas City Commercial Real Estate, as well as the rest of the United States, we use Net Operating Income, or NOI for the income portion of the equation. Here comes your second free definition of the day! Here is the simple equation to calculate NOI:

Gross Income - Operating Expenses = Net Operating Expenses

When calculating NOI, do not include debt service or interest from the debt. Once you have the NOI, it is easy to calculate cap rates and property values:

Cap Rate = Net Operating Income / Property Value

10% = $10 / $100

6% = $10 / $166

12% = $10 / $83

Property Value = Net Operating Income / Cap Rate

$100 = $10 / 10%

$166 = $10 / 6%

$83 = $10 / 12%

Now you can use cap rates!

*For simplicity sake, this is roughly the going rate for US apartment properties for the trailing 12 months according to Real Property Analytics.

I really like Robert S.'s answer below (and all the other answers as well).

I thought that I would try to expand on it somewhat...

There are actually two different cap rates. One is impirical (observed) and the other is hypothetical (structured from the variables that go into determing return on investment).

If several comparable properties have sold at a 10% cap rate, then one might divide their Net Operating Income (NOI) by 0.1 to obtain a "value" for their subject property.

The hypothetical cap rate is more complex. It requires that you consider and ascribe a percentage to each of the concepts of Return Of Investment (100% divided by the usefull life of the property) and Return On Investment (the total of Safe Rate + Loss of Liquidity+ Management + Risk). The total of Return On plus the Return Of equals the hypothetical cap rate. ( You can find more on this subject in a paper that I wrote which can be found on my LinkedIn profile. )

The importance of the hypothetical cap rate for example is that it can reveal to you the insanity of a particular marketplace. Leading up to the real estate crash of 2008, impirical cap rates were as low as 3% for multifamily to 7%% for offices, retail and industrial. At the same time, hypothetical cap rates were 8% to 13% for the same categories of property. In other words, prices at the time were sky high and it was definitely a time to sell and not to buy.

Cap rate is: the return on investment based on a non leveraged (cash) purchase. Sometimes you just got to keep it simple.

A Capitalization Rate is merely nothing more than "converting" the net operating income (NOI) of a property into an indication of value. The basic formula is NOI/ Sales Price = Capitalzatin Rate. For my money this Direct Capitlaization is preferred becaue it "can" be the most reflective indicator of what is actually happening in the marketplace. However, different type of properties have different cap rates to reflect the type of tenant, type of property, and risk associated with each. Some investors do not wish to take on much worry or management responsibiity so they may be more interested in single tenant triple net leases with natioinal companies. The downside to this is, as we have recently seen, many national tenants have taken bankruptcy and courts have voided leases. Thus, an empty building. However, many multi tenant properties spread the risk and increase the UNLIKELYHOOD of having a vacant buildng, but require more management. Debt service is NOT included in calculating an NOI for the simple reason that one investor may pay cash for a property and have no debt srvice while another investor leverages his purchase with say a 75% loan and he will have debt service. This would obviously cause different returns to these investors. Thus, the ony way to level the playing field and compare apples to apples is to calculate the NOI without Debt service. Cap Rates can be very reflective of the marketplace when there is an active marketplace is active and the sales used are recent. The reason is that current participants in the market will have already factored in international, national, and state and local concerns and their purchase decisons show what the marketplace is for that type of property in the current marketplace. Two year old sales could be significantly off, especially in the current economic climate. Discounted Cashflow projections are just that projections! The further out in time a DCF goes the less reliable it becomes in my opinion. Think about it, ten years ago we didn't have wars, the huge debt increases, fuel at $3.50-$4.00 per gallon, not to mention the new health care bill and all the talk about taxes. The smaller the property the less reliable a DCF is, the smaller the marketplace the less reliable, and the longer the project period the less relaible it is. DCF's should be reserved for larger properties with a good mix of credit tenants and longer terms leases.

All, but one of the answers are correct. However the one major issue I see in all the answers is that no one discussed knowing your market. The CAP RATE can help determine value, however you need to know if the NOI is based on the present market LEASE VALUE. Many buildings have Tenants that are paying above market rental rates. An example would be an Office building that present tenants rents average $12.00 per SF for the last three years and 30% are going to expire in next year and the remainder in the next 3 years and the present market rate for the same type of space is $8.00 per SF. An investor would be in big trouble if they purchased the building based on the last three years NOI. Our business is built on repeat clients that look to us for guidance. Find a good Mentor or ask for help even if you have to pay a referral fee until you get a complete understanding of the Investment Business.

Capitalization Rates (Cap Rates) are to income property like Annual Percentage Rates (APR) are to Certificates of Deposit. It is the ratio of income the property produces (Net Operating Income) divided by the current value of the property.

You would ask your seller for their last years taxes for the property, or for an Income & Expense Statement. Remember to add back Depreciation, Amortization & Interest to the Net Income figure. Divide your Net Income Figure by your asking price & you will have your Cap Rate.

As an Example, if your building generates Net Operating Income of $75,000.00 per year and your asking price is $1,000,000.00 then your Cap Rate would be 7.50%.

Great perspectives! What is in your overall cap rate? For what is the scope and purpose for which you using the overall cap rate for? Return of investment? Return on Investment? Real Estate Taxes? Debt Service? Equity? Levered? Unlevered? Measuring risk? Going in Rate/yield? Terminal Rate/yield? Etc? Lots to truly consider! Thanks for your thoughts! Love it!

The rate of return an investor is expecting based on paying all cash for the property.

Of course this is not reality as in most circumstances an investor is going to finance the property which then the calculation becomes more of a "cash on cash" return.

Utilitzing this definition you can easily compare this return to the return you would receive on money market accounts, CD's, etc.

The best short answer to this question is the CAP Rate is the UNLEVERAGED Annual Rate of Return on an income producing asset at a given price.

If you would like to learn more about financial analysis and how you can analyze any investment real estate, please visit www.reiwise.com or contact sales@reiwise.com for a free trial of the world's #1 Online Financial Analysis & Marketing Platform for Commercial Real Estate.

Wikipedia defines as: Capitalization rate (or "cap rate") is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. Essenially, it is the rate of return an experienced investor expects to achieve for similar properties. The rate is calculated in a simple fashion as follows:

Capitalization rate = Annual Net Operating Income / Value or Cost. This is expressed as a percentage. The reason the cap rate is so important is that lenders are focused on the income approach of the appraisal. And that is where the cap rate is used.

All good answers however just make sure that the NOI for the property is actual and not projected. Unless you have the actual NOI numbers that the property is generating you might end up paying too much if you cannot in fact get the rental rates you need to justify the price.

If there are not actual NOI numbers available it may be best to use comparable sales to determine a good per square foot market price.

Other than the answer, the real question should be how do you know the seller is not adjusting the numbers (NET annual income) to his or her benefit? If you use the sellers tax return as a basis, beware the numbers are quite often an not a true picture.

I am impressed with all these great answers on what CAP Rate means. Analyzing the CAP rate of one investment compared to another is only one of many tools that should be utiilized. Obviously it is important to calculate this Rate from both a current and projected NOI (will rents remain the same, go down or up?). Remember to use current expense information and consider deferred maintenance items like a damaged roof and pavement that will have to be repaired soon. Or maybe the investor can charge more rent if he rehabs the building.

Capitalization rate is a measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost which would be the original price paid to buy the asset

First.. its called the overall capitalization rate.. which is basically the rate of the return on the investment... return on and return of. .. think of it this way, if you have money in a passbook account the rate of return... (interest rate) is the percentage they are paying you for leaving the money in the bank. The risk involved in real estate ownership also has a rate of return.. and that is the overall capitalization rate for the investment in the property. Where to find? these rates can be found on the Appraisal Institutes web site. Hope that helps!

Cap rate is like MPG for comparing the fuel efficiency of cars. Its a quick number to help you compare the value, return and desirability of property. You won't necessarily achieve that number but it helps you to compare. Is that property a Porch or a Prius?

Cap rate is noi/ value. It does not not consider: leverage, risk, appreciation, or tax factors like depreciation, age of property. Cap rate is a wonderful tool, but not the complete answer to what a broker or owner should know about a property. Predictably cap rates vary by area, property type and risk. Low risk has lower cap rate than higher risk.

In comparison to the bond market it is today's return in relation to today's price. It is not the same yield to maturity to internal rate of return, each of which consider the future residual values.

Facts

• The higher the CAP rate the more risky the investment

• CAP rates are influenced by the opportunity cost for your money. e.g. If banks pay 10% on your deposits, CAP rate should equal or higher

• Negative leverage happens when the cost of borrowing money is higher than the CAP rate of a property

• Apartments building are less likely to be evaluated based on CAP rate than commercial

• CAP rate doesn’t account for appreciation of the real estate

• The reciprocal of CAP rate is (1/cap) is the number of years it takes to pay back for the investment