Today I am going to explain the cap rate. In addition to a simplified definition I will give use cases and provide a few exercises to test your newfound knowledge.

What is a cap rate?

A cap rate is used to compare the value of income producing real estate. There are many different asset classes — types of real estate — and no two buildings within an asset class are the same. This variety requires a metric that can measure value and value creation and that is easily translated across the entire spectrum of real estate. That metric is the cap rate.

Cap rate is short for capitalization rate and is defined as the net operating income of a property divided by the sale price of that property. Cap rates are expressed as a percentage and are typically in the single digits to low-teens.

Cap rate is short for capitalization rate and is defined as the net operating income of a property divided by the sale price of that property.

The cap rate is a measure of how much an investor is willing to pay for a certain amount of cash flow. The lower the cap rate the higher amount the investor is willing to pay.

The cap rate will differ by building type, market, and quality. There are companies that collect cap rate data from across the country so that investors can track the prevailing rates in different markets.

In addition to being a useful tool for comparison between assets, cap rates can also help measure the change in value over time. As market dynamics shift, cap rates can change for a given asset class and a given amount of NOI. Cap rate expansion is when cap rates increase over time, and cap rate compression is when cap rates decrease over time. Cap rates are inversely proportional to value, so as cap rates go down, values go up!

Wait, what is NOI?

To understand cap rate you also need to understand NOI. NOI or Net Operating Income is the revenue of the building minus expenses. If a building produces $1M in revenue per year (mostly from rent) and costs $200K to operate, then the NOI is $800K per year.

NOI or Net Operating Income is the revenue of the building minus expenses

Simple Math

If you know two out of the three terms in the cap rate calculation, you can discover the third. This simple math makes the cap rate a great comparison tool.

If you know the NOI and the cap rate, you can calculate the sale price. If you know the sale price and the cap rate you can calculate the NOI. Of course, if you know the sale price and NOI you can calculate the cap rate.

• Sale Price = NOI/Cap Rate
• NOI = Sale Price * Cap Rate
• Cap Rate = NOI/Sale Price

This math comes in handy if you are trying to figure out how much a similar asset would be worth given a recent comparable sale. For example if you are looking at two apartment complexes, Complex A has NOI of $5M and Complex B has NOI of $15M. You know complex A just sold for $100M, therefore the cap rate is $5M/$100M=5%. Assuming Complex B is comparable in quality and location, then how much is Complex B worth? If you divide the NOI of Complex B by the market cap rate ($15M/.05=$300M) you get a value of $300M or three times the value of Complex A. This makes sense because the income from Complex B is 3x the income from Complex A.

Conclusion

I hope you enjoy this explanation of cap rates. Please take some time to try the exercises below. Just remember, if you have two of the three terms (NOI, cap rate, and value) you can always calculate the third. I have made them difficult, but if you can get the answers, then you are a cap rate master!

If you have any questions, please let me know! My email is [email protected]

Exercises

1. If the sale price is $20M and the NOI is $1.5M, what is the cap rate?
2. Investors are willing to pay a 3.5% cap rate for industrial buildings in Anytown, USA,. If a building has a sale price of $55M, how much NOI does it produce?
3. Office building A recently sold for $10M at a cap rate of 9%. A comparable office building is on the market for $20M, what is the NOI of the second building?
4. Over a one year period, the NOI of a building has stayed consistent at $1M, but cap rates have compressed from 5% to 4.5%. How much has the value of the building changed in that year?

If you have suggestions for future demystifications, let me know on Twitter!