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.