The capitalization (or ‘cap’) rate is a term that is used frequently in real estate asset sales and purchases. The cap rate is a ratio of two variables: net operating income and the current value or sale price of a property. Another way to think of the cap rate is that it is the rate at which the net operating income recapitalizes the asset value on an annual basis.
Capitalization Rate = Net Operating Income (NOI) / Current Market Value (or Sale Price)
For example, if an investment group buys an apartment property in Los Angeles with an annual NOI of $1,000,000 for $20 million, the cap rate is 5%:
$1,000,000 / $20,000,000 = 5%
In this example, the asset is producing 5% of its value in income every year. At this rate, the asset will pay for itself in 20 years.
How are cap rates used?
Cap rates are used in various ways when analyzing real estate investments.
Investment groups may use cap rates internally to compare and contrast investment opportunities. There are a number of other factors that go into those real estate decisions, but the investment group may weigh the pros and cons of buying one asset with a higher cap rate than another.
Cap rates may also be used as a benchmark to gauge industry trends across asset classes related to pricing. In that regard, cap rates may show supply and demand and what buyers are willing to pay for properties. Over time, they may be useful to discern patterns or breakouts.
Cap rate considerations
While cap rates can be a good metric to compare and contrast different investment opportunities, as well as a measure of market trends, note that not everyone calculates NOI in the same way. Some investors use 12-month trailing income while others will make assumptions based on predictions of higher income in the next 12 months. This is referred to as trailing vs. forward-looking cap rates, which can produce radically different cap rate results.
Conversely, the purchase price may not be a direct reflection of the NOI that supports it. Suppose a suburban office building requires significant capital improvements. That office building might sell for a lower price since the next buyer will need to invest a large sum into capital improvements upon acquisition. In that scenario, a higher cap rate may be justified compared to a similarly situated office, even if the NOI is the same for each.
In short, the cap rate can be a useful tool that is often used alongside other criteria to assess real estate investment opportunities and draw conclusions across asset classes. Keep in mind that understanding how NOI relates to cap rates is critical in utilizing cap rates as a resource, as well as understanding that cap rates are an estimated return that can change over time.
For more information on the cap rate, refer to this article: What is a Cap Rate?