The capitalization rate (or cap rate) is often seen on listings for investments being sold, but what is it and how relevant is it? The cap rate is essentially another yield calculation that takes the net operating income and compares it to the value of the investment. The primary calculation is: CAP RATE = NOI ÷ VALUE, where value can either be the purchase price or the estimated value of the asset.
Cap rate is a great calculation for a number of reasons:
- Simplicity – If you know the net operating income and the purchase price, you can quickly do some back of the napkin calculations to determine yield.
- Expenses – The cap rate is determined by the NOI, which means that the calculation takes into account the expenses of the property including vacancy, credit losses, operating and miscellaneous expenses.
- Comparisons – Cap rate is often the most used calculation in commercial real estate, so it has the ability to create an “apples to apples” comparison among various assets, regardless of the type (industrial, retail, etc.).
Yet for the reasons stated above, the cap rate can also be a misleading figure when analyzing an investment:
- Limited picture – Due to the simplicity of the calculation, it also leaves out some very important information that is key to understanding any investment including not taking into account debt or any tax implications associated with the investment.
- A snapshot in time – Cap rate is also a reflection of the first year’s income and/or first year’s value, meaning that it’s not great when looking at properties with upside or unstabilized NOI’s. Remember that the cap rate is a snapshot in time looking backward, not forward.
- Skewed value – Cap rate can also be manipulated in a way that makes the property appear better than it actually is. It’s imperative to look at stabilized incomes and not “pro forma” NOI’s when doing your analyses, so that you fully understand how a property performs over time…and in the future.
The capitalization rate is a great way to quickly see if an investment is worth looking into, but just make sure that you look further beyond those numbers to truly understand how a property will perform over time.