Back to Basics: What is a Cap Rate?
June 22, 2017
As real estate investors, we see the words “cap rate” often, and may even use it ourselves when comparing investments. But in fundamental terms, what does it mean, and why should we care? We could write a book on the nuances and advanced discussions, but for now let’s focus on the basics:
Capitalization rates, or cap rates, is quite simply a ratio comparing the Net Operating Income (NOI) of a property to its Sales Price (or value). For example, if a property produces $1,000,000 of annual NOI and was sold for $10,000,000, the property was sold for a 10% cap rate ($1,000,000 / $10,000,000 = 10%).
Using the example above, an investor paying $10 million for a property with $1 million of annual NOI would be earning a 10% annual rate of return on their investment (assuming they use no debt). If that investor was to use $10 million to purchase a property at a 7% cap rate, they would only expect to receive $700,000 of NOI.
A Measure of Perceived Risk
Why would an investor be willing to accept lower returns for the same investment amount? Simply put, cap rates are used to compare different real estate investments and their relative risks. There are many factors beyond the scope of this article that go into the cap rate a property is “worth,” but a short list would include:
- Geographic location (i.e. Los Angeles, CA, vs. St. Louis, MO or downtown vs. suburban)
- Asset Type (multifamily, office, retail, self-storage, hotel, etc.)
- Tenant credit quality
- Lease term
Common sense would say that an investor would pay more (lower cap rate) for, $1 million of annual NOI from a property leased 100% to Home Depot (“A” rated credit) for 10 years and no owner responsibilities located in a suburban area with a growing population, than $1 million of annual NOI generated from a hotel in a market where demand where population is shrinking (perhaps due to a major employer moving out of the market). Generally, an investor would be willing to pay a lower cap rate, and earn a little less return in exchange for knowing that Home Depot was obligated per its lease to pay the investor’s return than the investor would for the hotel that would require hands-on operations and daily occupancies tied to demand and room rate pricing.
Related post: Knowing Your 1031 Exchange Tax Deductions
Complications and Considerations
If we only needed to look at a cap rate to know the risk of a real estate investment, life would be easy. Unfortunately, it is not that easy. For example, in calculating NOI for purposes of cap rate calculations, some investors use 12-month trailing income while others will make assumptions based on predictions of higher income in the next 12 months.
In short, a cap rate is a useful tool that can be used to measure and compare risk across real estate investments. Keep in mind, there are many other considerations and metrics to factor in your decision making.
Please note: 1031RPS.com and its associated personnel are not tax professionals, and they recommend investors consult with their tax advisor to ensure their 1031 Exchange is within the IRS guidelines established.