What's a Cap Rate? Why does it matter?

A lot of times when viewing information on commercial real estate sales, the Capitalization Rate is one of the main measures to determine the rate of return on the investment. Cap Rate is calculated by dividing the (actual or expected) Net Operating Income (NOI) by the property's Market Value.

For example, a property worth (or listed for sale for) $1M, with an expected annual NOI of $100,000, would have a Cap Rate of 10%. In case you're asking how NOI is calculated, this is the annual net income after subtracting ALL expenses EXCEPT mortgage costs.

The reason Cap Rate matters is because it is a very simple, quick way for investors to compare similar investment properties in similar markets.

One thing to be aware of when looking at and comparing Cap Rate is that this takes into account the CURRENT value and CURRENT NOI. This is not a good indicator of investment returns or value if the property's use, condition, etc. is about to change or if the NOI is about to change.

In using the $1M property value example above, and assuming this is an apartment complex: If an investor were planning to purchase the property for the $1M, but also planned to spend, say, $200k to rehab the property, which would result in increased rents, this would ultimately raise the NOI and thus, raise the cap rate. In this case, depending on the market, the 10% Cap Rate could reviewed as a nice discount, or good investment. Conversely, if the property were already in " tip top" condition, already generating higher than market rents, this cap rate could be viewed as being "more expensive". So it's always good to remember that Cap Rate should only be a good starting point, or general barometer for valuing investment properties and that there are many more factors that go into the ultimately value of a property.

If you have any questions, comments, or additions, please share!