Cap Rate, which is a very commonly used measurement and comparison tool, reflects a one-year relationship between Net Operating Income (NOI), and price (or value). NOI, which is a very key figure in investment analysis of all types, is defined as rents received from all sources, minus owner-paid Operating Expenses. For our purposes, we will use the simplified rent minus Operating Expenses equals NOI. In the real world, NOI Calculations usually involve an allowance for Vacancy and Credit losses (VNC losses). These VNC losses used in the calculation of NOI could be the actual vacancy for the property, a “Market” VNC percentage for that type of property, in that particular market, or the stated VNC losses. Stated VNC losses could be dictated by a lender, or potential Investor, and would usually be greater than actual or market vacancy, which is done to take a more conservative view of income. The formula for determining Cap Rate is: Cap Rate is equal to NOI divided by price.
Cap Rates, as is the case with any measurement criteria, can be used as a measure of performance, or comparison. In measuring performance, Cap Rate gives us the one-year unleveraged yield for the property. That is, what the first year return on the investment would be if the property were purchased for all cash (no mortgage or debt).
CAP RATE AND CASH ON CASH RATIO'S We refer to Snapshot Comparisons as those analysis vehicles that evaluate the performance of an investment property, at a moment in time. Snapshot Comparisons provide important information about a property; however, they are rarely used as the only criteria in making a buy, or a sell decision. They are often used, however, as a qualifying factor in determining whether to take the next step in the buy or sell process.
Some of the shortcomings of Snapshot Comparisons are that they do not consider changes, trends, or market condition. They look only at the present, or the immediate future. Two of the most common Snapshot Comparisons are Cap Rate, or the use of Cap Rate to determine property value, and Cash-on-Cash.
Here is a very common, and often used example of calculating the Cap Rate for a property. In our example, the property has rents of $35,000. Owner-paid Operating Expenses are $25,000. And, the property is being offered for a sales price of $130,000. We need to calculate the Cap Rate at which this property is being offered.
Rent minus Operating Expenses gives us a Net Operating Income of $10 000 The Cap Rate Rent minus Operating Expenses gives us a Net Operating Income of $10,000. The Cap Rate
formula, which is Cap Rate is equal to NOI divided by price, results in a $10,000 NOI divided by $130,000 price. This equals a 7.7 percent Cap Rate.
As you can see, Cap Rate is a simple and straightforward calculation. Taken further, if we experiment in this example with higher and lower offering price for the property, we will see that Cap Rate has an inverse relationship with price. That is, a higher price results in a lower Cap Rate. And a lower price results in a higher Cap Rate for a given amount of Net Operating Income (NOI).