Cap Rate or Capitalization Rate - What Is It?

By
Services for Real Estate Pros with Loretta A. Steele Realty

Cap Rate

The Cap Rate or Capitalization Rate is term that is heard quite often in regards to income properties.  In this article the income property I will be referring to will be an apartment building.

What is a Cap Rate?

What is a good Cap Rate?

How do you calculate a Cap Rate?

And basically, why is the Cap Rate so important?

A simple definition of a Cap Rate would be a number, specifically a percentage that gives an estimate of the value of an apartment.  It sounds like all you need to know, would be the Cap Rate.  And then you know if the apartment is a good investment or not.  But wait!  Before you jump to that conclusion you need to look at what makes up a Cap Rate, or what is the formula for a Cap Rate.

There are two components of a Cap Rate, the Net Operating Income (NOI) of the apartment and the purchase price of the apartment.  The Cap Rate is the NOI divided by the purchase price and is represented as a percentage.

                                                Cap Rate  =  NOI / Purchase Price

The first component, the NOI equals the “potential gross income”.  Potential gross income is also known as the “gross scheduled income”.  Let’s say you have a 50 unit apartment building.  And in one year, you are able to collect all rents on those 50 units.   In other words, there were no vacancies in that one year and all your tenants paid their rent in full each month.  The income you receive in that year is the potential gross income.

Now we need to consider, vacancies and credit losses.  In a one year period, our 50 unit apartment building will likely have some unoccupied units.  And some tenants may not pay their rent.  So, the NOI must subtract the “vacancy & credit loss” from the “‘potential gross income”.

And finally, the NOI must account for operating expenses.  In order to continue to collect rents, you must maintain the building. Expenses that will help you maintain the apartment building, are called “operating expenses”.  Now, the definition of NOI is complete.  It is the gross scheduled income, subtract the vacancy & credit loss, and subtract the operating expenses.

                        NOI  =  gross scheduled income  -  vacancy & credit loss  -  operating expenses

Our definition of Cap Rate is complete.  NOI divided by the purchase price, represented as a percentage.

Before I go any further, I need to emphasize one very important consideration involving a cap rate as just presented.  The “purchase price” is based on an all-cash purchase.  Therefore, our 50 unit apartment building was or will be purchased with all cash, no loans were involved. 

Now let’s try these equations with some numbers.  I will work with some easy numbers just to simplify the results.  Start with an NOI of $100,000 and a purchase price of $1,000,000.

Cap Rate  =  NOI / Purchase Price              Cap Rate  =  100,000 / 1,000,000  = 0.10  à 10%

NOI divided by purchase price, gives us 0.10.  Cap Rates are presented in percentages therefore we multiply by 100 to get a percentage.  Our Cap Rate in this example is 10%.  Ok, great, we used some simple arithmetic and got number.  Now what?   How can we use this 10% Cap Rate? 

Say you are in the market for a 50 unit apartment building. And your broker has shown you an apartment with the 10% Cap.  Three days later your broker calls with another 50 unit apartment building a couple blocks from the 10% Cap apartment building.  But this apartment has an 8% Cap Rate.  Now you have two 50 unit apartments to consider. Your broker also tells you that both apartments have a NOI of $100,000.

Referring back to our formula for calculating a Cap Rate.  The NOI divided by the Purchase Price.  In this formula, your broker has already given you some valuable information.  You have the Cap Rates for both apartment buildings.  You have also been given the NOI of both apartments; apartment A and apartment B have the same NOI.  The only value you don’t have is the Purchase Price.  But from the formula, you can see that you don’t need the purchase price.  In fact you can transpose the formula and solve for the purchase price.

Cap Rate  =  NOI / Purchase Price      à    Purchase Price  =  NOI / Cap Rate

When we solve for the purchase price, the new formula shows how the Cap Rate converts the net operating income into a purchase price. Using this new formula, we can calculate what the purchase prices should be for both apartment buildings.

            Apartment A                                                    Apartment B

Purchase Price = 100,000 / 10%                    Purchase Price = 100,000 / 8%

Purchase Price = $1,000,000                           Purchase Price = $1,250,000

We see that the only difference is the Cap Rate.  Both have the same net operating income of 100,000 dollars but apartment A’s Cap Rate is 10%, whereas, apartment B’s Cap Rate is 8%.  Note that a lower Cap Rate produces a higher purchase price.  A 10% Cap down to an 8% Cap, increases the price by $250,000.

Now let’s consider the effects of the Cap Rate and the purchase price.  Multiply them together and you get the net operating income. 

NOI = Cap Rate  x  Purchase Price

Apartment A                                                  Apartment B

NOI  = 10%  x  1,000,000                                        NOI  = 8%  x  1,250,000                                

NOI  = 100,000                                                           NOI  = 100,000

This simple formula can be mathematically solved for each value in the formula.  If you have two of the three values of the formula, you can always solve for the third value. 

You may hear some people equate a Cap Rate to a rate of return for an investment.  But is the Cap Rate really equal to the rate of return.  Remember, one important element of a Cap Rate, when we used are previous formulas.  The Cap Rate was based on an all cash purchase of an apartment building.  No loans or leverage was involved.  But a rate of return takes leverage or loans into account.

Leverage, loans, mortgage or simply put, the money that is used to acquire a property must be accounted for in any calculation involving rate of return.  Therefore, a Cap Rate based on an all cash purchase can never equal a rate of return.  When anyone quotes a Cap Rate, make sure you know how that Cap Rate was calculated. 

Loretta A. Steele is the developer of AgentApt Analysis and APOD Extra, two rental property software products that will produce automatic calculations and marketing presentations, quickly and easily.  See for yourself at www.LincolnSteele.com

 

 

Comments (5)

David Popoff
DMK Real Estate - Darien, CT
Realtor®,SRS, Green ~ Fairfield County, Ct
Not bad, always did that in my head but for duplexes and not 50 unit buildings....small town rentals. :-)
Jul 17, 2012 09:31 AM
Evelyn Kennedy
Alain Pinel Realtors - Alameda, CA
Alameda, Real Estate, Alameda, CA

Loretta:

Good information about cap rate and how you calculate it.  Thanks.

Jul 17, 2012 09:44 AM
Erv Fleishman
Realty Associates - Boca Raton, FL
Luxury Prop Specialist Realty Associates

Run a Chi Square analysis to see if this actually works.

Collect the rent and make sure it is more then expenses. 

Math is too much.

Jul 17, 2012 09:45 AM
Loretta A. Steele
Loretta A. Steele Realty - Moreno Valley, CA

Erv,

A Chi Square analysis?  How about a Likelihood-ratio test to test whether there is evidence of the need to move from a simple model to a more complicated one.  But I don't want to turn anyone off by the statistical  discussion.

If the income does not cover all expenses, then that is just losing money and not investing.

And you are right, math is too much.

I am happy that people are reading this post.  Love the comments.

Jul 17, 2012 10:10 AM
Leslie G. Rojohn
MoonDancer Realty - Sylva, NC
GRI, ABR ~ MoonDancer Realty

I'm going to have to read this again when I am not so beat.  Spent a busy day gathering data for just such a situation.  Now I need a fresh brain to analyze it.  Thanks for the info.

Jul 17, 2012 12:29 PM