What is a Cap Rate on Real Estate and What is an Example of a Cap Rate?
Capitalization (Cap) Rate Definition
Simple definition: the cap rate (or capitalization rate) is the rate of return on a real estate investment based on the net operating income and the value of the property.
A cap or capitalization rate is a standard method for valuing the income stream of a property in comparison to the actual value of the property.
Capitalization Rate Explanation
The capitalization rate is a rate of return on the property, but I wouldn’t go so far as saying it is THE rate of return for a property. Confuse you yet? To better understand, let’s look at the capitalization rate formula’s.
Capitalization Rate Formula
As you can see, there are three factors used in the capitalization rate formula’s: 1) property value (i.e. sale price), 2) net operating income (NOI) and 3) capitalization rate. If you know the values for two out of the three you can calculate the third using these formula’s.
Example of a Capitalization Rate
I’m going to give you all three variables, but I’ll show you how to calculate the missing variable if you only have two out of the three. Assume for this example that the Net Operating Income (NOI) of the property is $120,000/year, the value (i.e. sale price) of the property is $1,500,000 and the capitalization rate (cap rate) is 8%. Let’s look at the math:
Who Determines the Cap Rate?
Because the capitalization rate is a factor of income and value, the income is set, but the value is determined by the market therefore the capitalization rate is determined by the market. The market will make that determination based on the risk of the property. Higher risk = higher cap rates, lower risk = lower cap rates.
There is an inverse relationship between the capitalization rate and the value of a property. All that really means is when the capitalization rate decreases the value of the property goes up and when the value decreases then the capitalization rate increases.
What is Net Operating Income?
Okay, I have the formula used to calculate the capitalization rate and I understand what the value of a property is, but what is the Net Operating Income or NOI of a property? We will dig into this in greater detail in a later post, but a simple definition is: net operating income is all of the revenue of a property less the operating expenses of the property. The calculation of Net Operating Income (NOI) is as follows:
While the above calculation is a pretty standard method used for calculating net operating income, some owners include certain expenses in their net operating income calculation while other owners believe these expenses aren’t part of the operating expenses of the property and therefore don’t include them in their net operating income calculation. As a result, you can’t always assume the NOI calculation of two investment properties is an “apples to apples” comparison. This leads us into some of the concerns with capitalization rates.
Concerns with the Capitalization Rate
I mentioned above that the capitalization rate is is a rate of return for a property, but I wouldn’t go so far as saying it is THE rate of return for a property. Why is that?
Real estate investors often use slang to describe “above the line” expenses and “below the line” expenses and their calculation for each might differ from each other. The “line” they are referencing is the net operating income (NOI) of a property. Expenses that are included in the net operating income calculation are “above the line” expenses and expenses that aren’t included in net operating income are “below the line” expenses. Some examples of “below the line” expenses are as follows:
- Capital Expenditures
- Tenant Improvement Expenses
- Leasing Commissions
- Expenses specific to the owner (e.g. travel, entity licensing fees, etc.)
- Debt Service
Typically, none of the above expenses are included in the cap rate calculation, but they should be included in the actual rate of return calculation for a property.
Some investors place debt on their property while others purchase the property all-cash. The rate of return for these investors will be different.
As stated above, another concern about capitalization rates is not every property owner classifies operating expenses the same way therefore some owners include certain expenses in their net operating income calculation and some owners don’t.
Capitalization Rate Conclusion
I discourage anyone from purchasing a real estate investment property merely because of the advertised cap or capitalization rate. Capitalization rates are typically a good starting point to use for comparing alternative real estate options, but further due diligence needs to be completed to determine the actual rate of return.
Clear as mud???
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