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Cap Rate Definition And Caveats

Let's start with a quick cap rate definition.

A cap rate or "capitalization rate" is used by investors to quantify the relationship between an asset's net income and its value. It is written as follows...

Cap Rate = Net Operating Income / Property Value

For example, if you are considering purchasing a piece of commercial real estate with an "NOI" of $250,000 and the asking price was $2,500,000, you could conclude based on those numbers that the cap rate was 10%...

Cap Rate = $250,000 / $2,500,000

Cap Rate = .10 or 10%

Flipping Around The Cap Rate Definition

Alternatively, if you were considering purchasing an asset (say an apartment building?) and you knew what the average cap rate of similar apartments were, you could then attempt to derive a value for that asset. Of course you would have to know what the NOI of the investment property was as well. Using the same numbers as above, the value would be determined as follows...

Property Value = NOI / Cap Rate

Property Value = $250,000 / .10

Property Value = $2,500,000

If you could purchase the property for less than that amount, you would in theory be getting a good deal.

Keep in mind however, that you should only use the cap rate definition / formula above as part of a much larger analyzation process. You will also want to scrutinize very closely any figures that you are using in your calculations. In other words, don't take the NOI that the seller presents to you as the gospel.


Cap Rate Definition And Apples To Apples

Investors use cap rates in an attempt to simplify the relationship between like assets for the purpose of comparison. The problem is that, when it comes to real estate investment properties, no two are alike. Therefore it is difficult to really compare apples to apples.
Cap rates certainly have their place in the due diligence process, but beware not to put too much stock in this one tool!

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