What is the capitalization rate (cap rate)?
– Definition: The capitalization rate, commonly called the cap rate, is a simple ratio that expresses a property’s expected unlevered annual return. It equals the property’s annual net operating income divided by its current market value, and is reported as a percentage.
– Net operating income (NOI): annual rental and other property revenues minus recurring operating expenses (management, maintenance, insurance, property taxes, utilities). NOI excludes debt service (mortgage payments), depreciation, and income taxes.
– Current market value: the price the property would fetch in the market today (not necessarily the original purchase price).
Core formulas
– Cap rate = NOI / Current market value
– Alternative (less common) version: Cap rate = NOI / Purchase price
– Gordon (constant-growth) representation: If NOI is expected to grow at a steady rate g and investors require a discount rate k, then Value = NOI1 / (k − g). Rearranged, the implied cap rate = NOI1 / Value = k − g (assumes stable perpetual growth and no other adjustments).
What cap rate tells you (and what it does not)
– Quick comparison tool: It lets you compare yield across similar properties in the same market.
– Risk signal: Higher cap rates generally indicate higher perceived risk or lower demand; lower cap rates suggest lower perceived risk or stronger demand.
– Payback shorthand: Rough payback in years ≈ 1 / cap rate (e.g., an 8% cap rate implies ~12.5 years).
– What it omits: Cap rate is an unlevered, single-year snapshot. It does not account for financing (leverage), the time value of money, multi-year cash flow growth or decline, capital expenditures (major repairs), tax effects, or timing of cash flows.
When to use cap rates
– Best for initial screening of income properties and for valuing stabilized assets with predictable NOI.
– Often used to estimate a terminal (exit) capitalization rate when modeling a future sale.
Simple numeric example
– Suppose a small apartment building produces expected annual rents and other income of $180,000. Operating expenses (property taxes, insurance, maintenance, management, utilities) total $60,000 per year.
– NOI = $180,000 − $60,000 = $120,000.
– If comparable properties suggest a market value of $1,500,000, then:
– Cap rate = $120,000 / $1,500,000 = 0.08 = 8%.
– Interpretation:
– An 8% cap means an unlevered one‑year yield of 8% on the current value.
– Rough payback = 1 / 0.08 = 12.5 years.
– If you planned to finance the purchase, your levered (equity) return would differ because financing changes cash flows and risk.
Gordon model worked mini-example
– Assume an investor’s required return (k) = 10% and they expect steady NOI growth (g) = 2% forever.
– Implied cap rate = k − g = 10% − 2% = 8%.
– If next year’s NOI is $120,000, Value = $120,000 / 0.08 = $1,500,000. This matches the simple cap formula when the Gordon assumptions hold.
What affects cap rates
– Location and market demand (city center vs. outskirts).
– Property type and condition (office, retail, multifamily, industrial).
– Tenant creditworthiness and lease lengths.
– Local supply/demand trends and rental growth outlook.
– Interest rates and broader macroeconomic conditions.
– Expected capital expenditures and vacancy rates.
– Comparable sales and investor return expectations.
Is a higher or lower cap rate better?
– Neither is universally “better.” A lower cap rate typically indicates a higher-priced, lower-risk asset (strong location, stable tenants). A higher cap rate signals a lower price relative to NOI and usually higher perceived risk or weaker market fundamentals.
– Which is preferable depends on your objectives and risk tolerance: income stability and preservation vs. higher implied upside (and more risk).
Cap rate vs. return-on-investment measures
– Cap rate: Unlevered annual yield relative to property value; ignores financing and time value of money.
– Cash-on-cash return: Annual pre-tax cash flow divided by actual equity invested; includes the effect of debt.
– Total ROI or IRR (internal rate of return): Considers the timing and magnitude of cash flows, sale proceeds, and financing; captures time value of money.
Use cap rate for quick valuation and comparisons; use IRR and cash-on-cash measures for full investment analysis.
Limitations and cautions
– One-year snapshot: Cap rate assumes stable NOI for the year; it may mislead for assets with anticipated big near-term capex, lease rollovers, or redevelopment plans.
– Sensitive to assumptions: Small changes in
NOI or the market cap-rate assumption can swing estimated values materially. For example, a modest 0.5 percentage-point change in cap rate or a 5–10% change in NOI will meaningfully change implied property value. That sensitivity is why cap rates are best treated as one input in a broader valuation and underwriting process, not as a stand-alone verdict.
Common pitfalls and practical cautions
– One-year snapshot bias: Cap rate uses a single-year net operating income (NOI). If NOI is unusually high/low in that year because of one-time leases, tenant improvements, or deferred maintenance, the cap rate will misstate ongoing yield.
– Mixing apples and oranges: Cap rates vary widely by property type (office, industrial, multifamily, retail), lease structure (gross vs. triple-net), tenant credit, and local market. Don’t compare cap rates across dissimilar assets without adjustment.
– Ignoring capital needs: Cap rate does not include capital expenditures (capex) or reserves for replacement. Buildings needing immediate capex often deserve higher effective yields.
– Financing effects omitted: Cap rate is unlevered. It ignores debt service, so it does not indicate investor’s cash flow after financing.
– Market timing and liquidity: Observable cap rates come from recent sales. Thin markets, distressed sales, or agency/policy-driven transactions can push market cap rates away from fundamental values.
– Measurement inconsistency: Different sellers/brokers may calculate NOI differently (what expenses are included/excluded). Always reconcile definitions.
Formulas — concise
– NOI = Effective Gross Income − Operating Expenses (exclude debt service and depreciation)
– Capitalization rate (cap rate) = NOI / Property Value (or Sale Price)
– Implied Value = NOI / Cap rate
Worked numeric examples (step-by-step)
1) Calculating a cap rate from a sale
– Given: NOI = $120,000; Sale price = $1,500,000
– Cap rate = $120,000 / $1,500,000 = 0.08 = 8%
2) Converting NOI to value (valuation use)
– Given: Expected stabilized NOI = $150,000; Market cap rate = 6%
– Implied value = $150,000 / 0.06 = $2,500,000
3) Sensitivity demonstration
– Base case: NOI $150,000, cap rate 6% → value $2,500,000
– If NOI falls 10% to $135,000 at same cap rate → value $2,250,000 (10% fall)
– If market cap rate rises to 6.5% with NOI unchanged → value = $150,000 / 0.065 = $2,307,692 (≈7.7% fall)
This shows both NOI changes and small shifts in cap rate materially affect implied value.
Practical checklist for using cap rates in underwriting
1. Confirm NOI definition:
– Start with effective gross income (market rents less vacancy/credit losses).
– Subtract realistic operating expenses (utilities, management, taxes, insurance, repairs).
– Exclude debt service, depreciation, and lender-required reserves from NOI.
2. Normalize NOI:
– Remove one-off items (non-recurring leasing commissions, owner concessions).
– Adjust to stabilized occupancy and market rents where appropriate.
3. Select an appropriate market cap rate:
– Use recent comparable sales of similar property type, location, and lease profile.
– If comps are few, use investor surveys or institutional indices as a sanity check.
4. Account for capex and risk:
– If property needs near-term capex, increase required return or add a reserve line item.
– Reflect tenant credit risk and lease term structure (long-term NNN leases typically command lower cap rates).
5. Run sensitivity scenarios:
– Stress NOI by ±5–10% and cap rate by ±50–100 bps to see value range and downside.
6. Reconcile with other metrics:
– Compare implied value to discounted cash flow/IRR and cash-on-cash return under the expected financing plan.
Using cap rate with exits and IRR
– Purchase cap rate gives an entry-price perspective. For multi-year hold analysis, estimate a