CAP Rate

By Seth Lane, Director 

One of the most common questions asked when analyzing a commercial investment is "What is the CAP rate?" The Capitalization Rate or CAP rate is the rate of return on a real estate asset based on the anticipated income produced by the asset. This number, usually shown as a percentage, is expressed as the ratio between the Net Operating Income (NOI) produced by an asset or property and its cost or market value.  (NOI is the income produced less the operating expenses. It is important to note that NOI  is calculated before interest and income taxes are deducted.)

The ratio looks like this: 

CAP = NOI/Value

Here is an example: 

As an investor you find a building that is being leased by a pizza restaurant. The restaurant pays $1,000 per month in rent. The lease is NNN, which I explain in detail here. In this scenario, the net operating income of the property is $1,000 per month over 12 months or $12,000.00. The property is being offered for sale at a price of $120,000.00. In this case, the CAP rate is 10% or 0.1.

CAP = $12,000/$120,000

CAP = 0.1 or 10%

This means that each year you will recoup 10% of your investment, assuming the NOI stays constant. 

The CAP rate is the percentage of your investment you will recoup in NOI after one year. The lower the CAP, the lower the rate of return. The higher the CAP, the higher the rate of return. Some people like to think of it this way: A higher CAP = a lower price; a low CAP = a higher price. 

Who or What Determines the CAP Rate?

Many properties are marketed based on the market-driven prevailing CAP rate. The Bergstrom Center for Real Estate Studies at the University of Florida publishes a quarterly report - Survey of Emerging Market Conditions - which details the prevailing CAP rates in markets and asset classes throughout Florida. Your local broker or appraiser can give you insight into prevailing CAP rates in your market. 

However (I think this is very important), the market defined CAP rate should be used for reference purposes only. CAP rate is essentially a risk throttle. As an investor, the riskier the asset, the higher rate of return I am going to demand. Just like a personal loan ... the lower your credit score, the higher the interest rate you are going to have to pay your lender. 

Lets go back to our example about the pizza restaurant. This time, we find another identical building with a pizza restaurant and are comparing the two as investment options. Pizza restaurant #1 has signed a 1 year lease. Pizza restaurant #2 has signed a 5 year lease. The market says that NNN leased restaurant space should sell at a 10%. In this case, option #1 is much riskier than option #2. Therefore, an investor who is buying #1 should demand an above market CAP rate to mitigate their risk. The tenant could decide to not renew their lease, leaving the owner with an empty building and ZERO NOI.  CAP rate is not a market-driven one-size-fits-all pricing tool. 

As you evaluate your investment options, understanding the Capitalization Rate is very important part of your research. Be sure to remember to adjust your analysis based on your own personal risk assessment and investment strategy. 

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Virginia MacKoul

Virginia is a graduate from the University of Florida's College of Design Construction and Planning with a degree in Sustainability and the Built Environment, and a minor in Urban Regional Planning. Virginia joined the Front Street team in 2011, as an intern. Upon graduation, Virginia joined the Front Street team full-time as the Director of Client Services. Ms. MacKoul’s addition furthers Front Street’s continued growth and expansion within Gainesville and other North Central Florida markets. She was promoted to Director of Marketing in 2014 and now manages the firm’s team of interns and oversees all marketing and branding activity. Virginia was born in Boston and moved to Lee County, Florida in 1997. Virginia graduated her high school's International Baccalaureate program and started at the University of Florida with a focus on Architecture. Virginia shares Front Street's passion of giving back to the community and those in need. Virginia's hobbies include photography, cooking, football, movies, music, and spending time with her dog, Brinkley.