I’ve explained cap rates (capitalization rates) dozens of times and it always seems to cause confusion, so maybe it will be easier just to put it down in writing. I think cap rates are probably confusing because they can be used in two different ways.
Cap Rate is used first and foremost to determine the value of a cash flowing investment property or commercial property.
Step 1: The property is categorized by quality level, location, type, etc. and the market value cap rate is determined from comparable sales. Usually a cap rate range is determined, for example, A-class apartments in South Minneapolis Uptown area may be selling for 5-5.5% cap rates. C-class apartments in North Minneapolis may be selling for 10.5-11% cap rates. So the first step is to determine what the market cap rate for a particular type of property is.
Step 2: Next, the cash flow or net income (NOI) is determined for the property. This can be gleened from the profit&loss statements (P&L) from the owner, verified by their tax returns and other data. Always be cautious in using owner supplied data to value a property. They are incentivized to skew the data. Cash Flow is simply the income that the property generates after all expenses, financing costs are not included. If an apartment in North Minneapolis has gross rents of $200k/yr, expenses of $100k/yr, then the NOI is $100k/yr.
Step 3: Divide the NOI by the market value cap rate for that type of property. For our North Minneapolis apartment buildling, you would take NOI $100k / 10% cap rate to get $1 million valuation. An A-class apartment in Uptown with a 5% market value cap rate with the same $100k NOI would be worth twice as much at $2 million. This is because that property is much more desirable for investors to own. Investors think that the A-class apartment will have fewer problems, lower liability, stable occupancy, lower capital repairs, better appreciation, and better tenants. Big investment funds like to invest in A-class properties and they are ok with the relatively lower returns, which drives the cap rates down and the values up. As you can see, if cap rates are lower, property values are higher.
Now, here’s where it can get confusing. A cap rate on an individual property can also be calculated to determine how it is performing compared to other similar properties. If North Minneapolis apartments are valued at 10% cap rate, then when you look at a particular investment you will want to calculate whether that property is at 10% or better. If a particular property is priced at $1 million and the NOI is $80,000, the cap rate is: NOI $80,000/ $1 mln Price = 8%. If the market cap rate in that area is 10% and this property is priced at an 8% cap rate, that would tell you it is overpriced. You would want to offer $800,000 or less in this case to ensure that your purchase cap rate was at 10% or higher.
I hope this helps clear up any confusion about cap rates. If you have any questions or comments, feel free to reach out.