An Introduction to Cap Rates for Commercial Real Estate.
Capitalization rates, or cap rates for short, are one of the most powerful tools in commercial real estate.
Formally referred to as income capitalization or the capitalization method, the concept is widely used by investors, brokers, bankers, and appraisers to estimate the value of a property.
The formula is straightforward:
Value = net operating income (NOI) / cap rate.
Stated another way, if you capitalize the net operating income of a property by the market cap rate, you’ll get an estimate of the property value.
Let’s unpack the formula a bit more before getting to an example.
NOI is calculated as follows:
Gross (or total) revenue for the property
- total expenses for the property (ie/ property taxes, insurance, maintenance, management, etc)
= Net Operating Income
A cap rate can be determined by looking at what other similar properties have sold for. If the sale prices and NOI’s of those comparable properties is known, the formula can be reworked to calculate each respective cap rate.
Cap rate = Value / NOI
Let’s give a couple of examples of hypothetical sales:
Example #1: Sold for $1,000,000. NOI was $100,000.
Cap rate = $1,000,000 / $100,000 = 10%
Example #2: Sold for $1,240,000. NOI was $115,000.
Cap rate = $1,240,000 / $115,000 = 10.78%
Example #3: Sold for $1,150,000. NOI was $120,000.
Cap rate = $1,150,000 / $120,000 = 9.58%
Some personal judgment will be required to determine what the market cap rate will be, but for this simple example let’s use 10%.
If you’re working with a particular property with an NOI of $130,000, you can divide that amount by the cap rate of 10% to get an estimated value of $1,300,000.
This is the power of using the capitalization method.
After all, it’s quick, easy to understand, and used across the world by small and large investors alike.
It is an indispensable tool but it’s important to note that a deeper dive into the method asks more questions than it answers. For example, what number is used if the property is vacant? Is a vacancy and credit loss variance accounted for? Is it stabilized net operating income? How do you account for escalations in rent? And perhaps the biggest existential question in real estate: What is value anyway?
These questions (and virtually endless more) require a lot more work to answer, and it’s often why the cap rate method is the first step of many in properly analyzing an investment. But while the cap rate method has notable limitations, don’t let it detract from the overall value it offers.
Cap rates are discussed all day, every day in the commercial real estate industry so it’s imperative to have a thorough understanding of how to use the calculations.
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