What is a Cap Rate

What is a CAP Rate?

by Michael Setunsky

The Wikipedia defines the Capitalization or CAP Rate in part as:

            A contraction of capitalization rate, the cap rate is the assumed rate of return on an investment in real estate. The cap rate is commonly used in the valuation of commercial and investment property because it directly links the value to the income produced by the property.

To determine the cap rate of a property, divide the net operating income by the sales price. From an income standpoint, the higher the cap rate, the better the deal.

Note that a higher cap rate results in a lower value. Thus, newer properties in upscale areas will tend to show lower cap rates than their less desirable counterparts.

Retrieved from "http://en.wikipedia.org/wiki/Cap_rate"

As an example for establishing a CAP Rate and ultimately determining the Sales Price for a property, let us use a 10 unit apartment building. The market rent for each unit is $1,500.00 per month for a total Gross Income of $180,000.00 per year. An estimated 1 unit is vacant at any given time. This gives us a Vacancy Rate of 10% (1 unit / 10 units = 0.1 or 10%). Before we can determine the CAP Rate, we have to resolve the Effective Gross Income (EGI). The EGI is derived by taking the Gross Income and subtracting the Vacancies and Collections. This gives us an EGI of $162,000.00 ($180,000.00 - $18,000.00).

Our next step is to calculate the Net Operating Income (NOI). The NOI is derived by subtracting the Operating Expenses from the EGI. The Operating Expenses consist of all the costs associated with the operation and maintenance of the apartment building (e.g., taxes, insurance, utilities, payroll, administration, property management fees and reserves for replacement). Operating Expenses do not include mortgage payments, capital expenditures and depreciation. The EGI is $162,000.00 and our Operating Expenses are $42,000.00. The NOI is derived by subtracting the Operating Expenses from the EGI. This gives us an NOI of $120,000.00 ($162,000.00 - $42,000.00).

The CAP Rate is determined by the commercial real estate market for the specific type of property and geographic area. The CAP Rate is specifically derived by looking at other apartment buildings in the local area that have recently sold. By using the formula CAP Rate = NOI / Sales Price for three to five comparable apartment buildings in close proximity, we can determine the CAP Rate for apartment buildings in the local area.

                                                 NOI                      Sales Price                       CAP Rate

     1.      Comparable #1   $105,000.00              $1,400,000.00                       7.5%

     2.      Comparable #2   $112,500.00              $1,500,000.00                       7.5%

     3.      Comparable #3   $131,250.00              $1,750,000.00                       7.5%

Looking at all three CAP Rates, we can choose a rate of 7.5% to use in our analysis. Based on our NOI of $120,000.00 and a CAP Rate of 7.5%, the Sales Price for our apartment building is $1,600,000.00 (NOI / CAP Rate = Sales Price).

Here is a summary of the math formulas:

     •     Gross Income - Vacancies and Collections = Effective Gross Income (EGI)

     •     Effective Gross Income (EGI) - Operating Expenses = Net Operating Income (NOI)

     •     Net Operating Income (NOI) / CAP Rate = Sales Price

Of course, if you know the Sales Price and the CAP Rate you can find the NOI:

     •     Sales Price x CAP Rate = Net Operating Income (NOI) or

If you know the NOI and Sales Price, you can acquire the CAP Rate:

     •     NOI / Sales Price = CAP Rate

The most difficult part of this whole process is developing the CAP Rate. If you do your homework and find the appropriate comparables, you should have no problem with the CAP Rate.

Note: The analysis here is only for demonstrating the Capitalization process and formulating a Sales Price on a property for marketing purposes. The intent here is not to circumvent consulting with an Appraiser and obtaining an appropriate appraisal on the property.

About the Author: Michael Setunsky is the Broker and owner of Michael's Commercial LLC serving the Northern Virginia commercial real estate market. His more than 23 years of experience as a commercial real estate and business broker has earned him the distinction for being one of the top commercial real estate producers in the Mid-Atlantic Region. He also serves on the Mid Atlantic Real Estate Marketing Association's (MAREMA) Board of Directors, and is a Commonwealth of Virginia licensed Instructor. He teaches Pre-licensing, Post Licensing Education, Broker's and Continuing Education courses. Visit his company web site at http://michaelscommercial.com/.