The capitalization rate, or cap rate for short, is an asset’s unlevered (no mortgage) return, and a reflection of an asset’s relative risk. If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment.  Cap rates are seen as a measure of risk and return, a “low” cap rate of 3-5% would mean the asset is lower risk and higher value; a “higher” cap rate of 8-10% reflects a lower price, higher risk and higher return.

How is the Cap Rate used?

The cap rate is a metric that a buyer can use to compare the price of an asset in the market with other similar properties that have sold in the last 6 months (or longer) and to track trends in the market over set periods of time. Buyers use the cap rate as a way to determine if they are getting a deal on a property they are looking to purchase by comparing it to the prior sales prices of other similar properties in the market. Brokers and sellers use cap rates as a sales tool to attract buyers to the asset by showing transparently how they priced the asset and to entice interested parties with an asset’s potential yield.

Cap rates can also be used to quickly estimate a property’s value when considering a refinance. If a property owner wants to consider a refinance, they may need an estimated value to determine what potential loan amount the property supports using the lender’s loan to value (LTV) metric. Once the estimated value is calculated, the owner can determine whether a refinance is possible, or even worth it.

Some buyers use future estimated cap rates to model the projected return of a property before it is purchased. A financial “model” is put together in excel to determine a project’s projected return profile and to see if it meets the buyer’s return targets. The model uses the purchase price, closing costs, the senior debt, projected income and expenses with growth over the anticipated hold period, as well as a projected exit price and potential profit.

Calculate Cap Rate

To calculate the cap rate, all you do is take your monthly NOI and multiply it by 12 (to get the annual number) and divide that number by the property’s current market value. The key thing to understand about cap rate is that higher is not always better. A higher cap rate generally denotes higher risk and higher return. While a lower cap rate, conversely, indicates a lower risk and lower return.

A good rule-of-thumb is to shoot for a cap rate in the 5%-10% range. Anything lower and the investment may not have enough yield, anything higher and you want to be sure you understand all the risks associated with the investment.

While Cap Rates are a useful metric, they should not be relied upon solely when analyzing an investment property, and have certain shortcomings that will be explored in part two of this series. Part three of the series will describe why cap rates are inappropriate for value-add transactions, and the final piece in the series will answer the question what should my target cap rate be?