In commercial real estate, the cap rate is often thrown around as the ultimate measurement for investment success. Brokers and agents use the cap rate to market a property as a good investment, while investors rely on it to determine if they will make money on a property.
But for something so universally used, it is a nuanced concept that is often misunderstood. There is no hard-and-fast standardization of numbers, and the formula may lend itself to a bit of embellishment. It is like when people use the term “the interest rate” but don’t know that there are many different types of interest rates. Or when comparing the mileage rate for different vehicles, you must consider the nuanced approach each company takes to test and measure that mileage rate.
So, what is a cap rate and why should investors be careful when relying on this number? Let’s have a look.
What is a Cap Rate?
A capitalization rate, or cap rate for short, is a term used to indicate the rate of return that can be expected from a particular real estate investment. The number is expressed as a percentage and is calculated using the net income of the property and its overall value.
The cap rate is a great tool for investors because it provides a singular number to look at to gauge if a certain property is a worthwhile investment. Note that the cap rate should only be used to compare similar properties because returns can vary greatly for properties in different areas or of different sizes.
How is the Cap Rate Calculated?
The calculation of the cap rate is quite simple. All you need is the net operating income (NOI)—or how much income the property generates after operating expenses, including maintenance and taxes—and the determined value of the property. The cap rate formula is as follows:
Capitalization Rate = NOI / Market Value
Say an investor is looking at a property that has market value of $1 million; the NOI for the property is $100,000. We would calculate the cap rate as follows:
$100,000 / $1 million = 10%
What to Look Out For
Adjustment of Numbers
Even with a formula as ubiquitous as that of capitalization rate, investors need to be careful that the numbers are accurate before making an investment decision. An honest mistake, unexpected market shift, or intentional adjustment of either the NOI or property value can make a seemingly incredible investment one that might elicit a second look.
In the above example, if tenant occupancy unexpectedly decreased and the true NOI was $80,000, and the property value decreased to $900,000 due to new zoning laws, the cap rate would be 8.9%.
Sponsor or Broker Trustworthiness
Cap rate is often used as a major selling point for properties and should be verified. When you look to invest in real estate, be sure to get all the financial statements and run the numbers yourself.
If you find that the numbers don’t match up, it is not necessarily intentional or a bad thing. Adjustments are often made to account for one-off events and expectations for future known changes in income or expenses. If the number is lower, the seller could be conservative with their numbers; underestimating income and overestimating expenses. The time to become wary is when the listed cap rate is significantly higher than what you calculate yourself—higher cap rates often imply higher risk, so double-check where the extra income came from.
Always compare properties as closely as possible on an apples-to-apples basis. For example, comparing commercial and residential real estate on a cap rate basis doesn’t make much sense. Be sure you have a similar property type to compare your numbers to make sure your investment aligns with where you are on the risk/reward spectrum.
The Usability of Cap Rates
The cap rate is an incredibly useful number for investors. But you must be sure that the number you are seeing is accurate. Errors can easily be made, and data can easily be cherry-picked to make the rate appear more favorable.
Due diligence (including receiving and reviewing financial documents) is incredibly important when basing your investment on this rate, and the cap rate should never be the sole factor in your investment decision. It is always best practice to consult with your legal or accounting team before deciding whether or not to invest.