May 25, 2022

# Cap Rate: Definition & Formula Explained

Cap rates are the most common tool utilized to evaluate real estate investments. However, the proper definition of cap rates is commonly misinterpreted by the real estate community.

This article explains the definition and formula for cap rates and explores an example and application of cap rates.

## Key Takeaways

- Cap rate is an important measure to evaluate real estate investments in comparison analysis
- Cap rate represents the expected annual return on a property if bought in all-cash
- Cap rate is the ratio of anticipated net operating income divided by the current market value

## What is Cap Rate?

Capitalization rate, also known as cap rate, is a metric of the anticipated return on investment if no debt is used for a specific year. In other words, the expected annualized unlevered return on investment.

Cap rate describes the relationship between predicted net operating income and current market value of the property.

Cap rate can also be viewed as a function of the risk premium plus the risk-free rate. Risk premium is the additional return an investor receives above the risk-free rate, commonly chosen to be the U.S. Treasury 10-year bond rate, due to holding a risky asset.

**Important Fact:** Cap rate represents a probable one-year return on investment and is subject to change over time.

## What is Cap Rate Formula?

The cap rate formula is defined as anticipated net operating income divided by current market value:

Cap rate is normally represented as a percentage, so the ratio should be multiplied by 100.

### Net Operating Income

Net operating income is calculated by the forecasted operating revenues, i.e. rent and amenity fees, minus the operating expenses i.e. management fees and property taxes. Shown as:

For cap rate calculations, net operating income is a projected value.

### Current Market Value

Current market value of an investment is determined by at the moment market conditions such as interest rates, supply/demand in the geographic location, and values of similar property types.

**Important Fact:** The price paid for the property and current market value does not correspond to the same magnitude. The price sold includes additional costs that do not provide value for the property i.e. closing costs and broker fees. The price of a property may equate to the current market value after a recent sale, but over time these numbers drift apart.

## What is an Example of Cap Rate?

Let's take a look at an example scenario where cap rates would be helpful. Assume that we are looking at two properties: *Office Building 1* and *Office Building 2*. *Office Building 1* generates $500k from rent per year, costs $100k per year to maintain, and has a current market value of $10 million whereas *Office Building 2* earns $1 million from rent per year, costs $280k per year to maintain, and has a current market value of $12 million.

We should invest in *Office Building 2* due to a higher cap rate, 6% to 4% respectively. Before we decide on *Office Building 2*, we should use other metrics such as IRR, cash-on-cash return, and yield on cost to compare these properties.

## What is Cap Rate vs Yield on Cost?

Commonly mistaken for each other, cap rate and yield on cost are similar measures of return on real estate investment properties but have different added value in comparative analysis.

Yield on cost involves a ratio of the expected annual net operating income over the total project cost. The net operating income is calculated in the same manner as in the cap rate, but the total project cost includes price, closing costs, improvement costs, etc.

The fundamental difference between cap rate and yield on cost is cap rate fluctuates over time depending on market conditions whereas yield on cost remains steady.

**Important Fact:** Total project cost is a static number and does not change over time in contrast to the current market value for cap rate.

## What is a Good Cap Rate?

Cap rate is a useful metric in comparative analysis of real estate investments due to the simplicity of the formula. Finding a "good" cap rate is subjective due to the variety of factors that affect cap rates. Industry leaders believe below 8% is a reasonable cap rate in most markets.

A buyer of a property looks for a higher cap rate as they want a higher return on investment, stemming from higher net operating income. On the opposite side, a seller of a property would prefer a lower cap rate due to a higher property value.

In general, higher cap rates compensate investors with higher returns on riskier asset classes.

*Multifamily Suburban Class A Cap Rates in US Metro Areas | https://bena-capital.com/news/2015/9/25/top-4-lowest-cap-rates-are-in-california-1*

It is important to note that markets play a significant role in the determination of good cap rates. As the Los Angles market tends to have lower cap rates compared to the Atlanta market as seen in the figure above. Nevertheless, the Los Angles properties may rise in value more than Atlanta properties over time, providing larger returns for an investor.

The concept of high-demand markets driving cap rates down due to higher property values is referred to as cap rate compression.

Property types have a similar effect on cap rates as markets. Demand for certain properties increases the current market value, which forces cap rates lower.

To determine a "good" cap rate, an investor must take into account all the factors afflicting property value and net operating income.

## What is Entry and Exit Cap Rate?

When analyzing a real estate investment, it is advantageous to have estimates of the entry and exit cap rates. Reminder that a cap rate reflects a return for a certain year.

Imagine we are thinking of investing in *Office Building 2* and exit in 10 years. We know the entry cap rate is 6% and forecast that the revenues will grow at a 3% rate and the expenses at 2%.

First, we need to calculate the net operating income in year 10.

Given that the *Office Building 2* market value in year 10 is $13 million. We can determine the exit cap rate for *Office Building 2* in year 10.

When comparing entry and exit cap rate, we want the entry cap rate to be greater than the exit cap rate to ensure gains on property value. However, in this scenario, *Office Building 2* has a higher exit cap rate than the entry cap rate, 8.20% and 6% respectively, so we should not pursue *Office Building 2*.