A Simple Definition Article by Gene: Cap Rates
Cap Rate is the standard performance ratio in Commercial Real Estate Analysis, and can simply be referred to as your return on investment (ROI).
In the world of Commercial Real Estate ratios, Cap Rate, or Capitalization Rate, is generally considered the most important indicator of the bunch.
The Cap Rate Definition in terms of formulaic application is as follows:
Net Operating Income / Purchase Price = Cap Rate
Simple, so let’s add some figures to the definition:
If you’re in possession of property with a $10,000 Net Operating Income, and you’re looking to sell for $90,000, your implied Cap Rate is 11.1%. ($10,000/$90,000)
Note: Cap Rate by definition is an isolated perspective of Real Estate Property as a whole, in other words, it foregoes many of the important factors contributing to real estate value, for example, Debt Service, Capital Expenditures, Age, Location, and a host of other commercial real estate analysis indicators.
That said, it’s probably the best and most accessible ballpark figure available.
Real World Definition: When an investor tells you they’re in possession of a property with a 10% Cap Rate, they’re essentially saying: my property returns 10% of the purchase price every year in net operating income.
Advanced Cap Rate Definition: An investor is less likely to actively search for a Cap Rate, but rather apply a predetermined Cap Rate to a net operating income in order to generalize a property value.
All we’ve done is rearrange the formula. It’s very simple, and we’ll look at an example.
Let’s say you’re looking to purchase a Property with an 8% or greater Cap Rate, and you find a property with a net operating income of $20,000.
If you divide the $20,000 net operating income by the 8% Cap Rate, you’d be willing to pay $250,000 dollars or less for the property in order to meet your minimum cap rate requirement.
Now say you have two properties:
1) Lakewood Estates: $30,000 Net Operating Income, $400,000 Purchase Price
2) Redefined Luxury Apartments: $25,000 Net Operating Income, $320,000 Purchase Price
Which is the better investment according to the definition of Cap Rate?
Lakewood Estate: $30,000/$400,000 = 7.5%
Redefined Luxury Apartments: $25,000/$320,000= 7.8% (Winner)
The Redefined Luxury Apartments return more on your investment, even though they produce a lower net operating income, the lower purchase price offsets the difference. The Redefined Luxury Apartments are the winning investment!