A property’s capitalization rate, or “cap rate”, is a snapshot in time of a commercial real estate asset’s return. Commercial real estate is an investment type, so the return is a reflection of the risk and the quality of the investment. The cap rate does not take into consideration a mortgage and is most useful in a market where sales occur often and prospective buyers can use the information from comparable sales of stabilized assets to determine if the price being offered is reasonable, relative to other sales.
The cap rate is determined by taking a property’s net operating income (the gross income less expenses) and dividing it by the value of the asset:
The following are two examples of how cap rate is calculated:
If a property sold for $1,000,000 and had an NOI of $100,000,
then the cap rate would be:
If a property sold for $2,000,000 and had an NOI of $100,000, then the cap rate would be:
What information is the cap rate actually providing? One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase. The cap rate is merely prediction of the returns that an asset will bring throughout the holding period of the investment given that the numbers do not change. The cap rate does not take into consideration a mortgage and is useful in a market where sales occur often and prospective buyers can use the information from comparable sales of stabilized assets to determine if the price being offered is reasonable, relative to other sales. For comparable sales within the same geographical area and specific time span, the cap rate can be one way to weigh the determine the possible risks and benefits of an asset.
