What You Should Know About The Cap Rate

The capitalization rate is a simple concept in the commercial real estate industry. Yet, it is misunderstood and sometimes improperly used often. This post will need a deep dive into the concept of the cap rate and get rid of some common misconceptions as well. What is a cap rate? The capitalization rate, just called the cap rate often, is the proportion of Net Operating Income (NOI) to property asset value. Let’s take an example of how a cap rate is commonly used.

17,000,000. In the industry-real estate business, it is common to say that this property sold at a 5.8% cap rate. What is the cap rate letting you know? One way to take into account the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase.

17,000,000 would produce an annual return on investment of 5.8%. Yet another way to think about the cover rate is that it’s just the inverse of the price/earnings multiple. As shown above, cap rates and price/earnings multiples are related inversely. Quite simply, as the cap rate up goes, the valuation multiple down will go.

What is an excellent Cap Rate? What’s a good cover rate? The short answer is that it depends upon how the cap is being utilized by you rate. For example, if you are selling a property then a lower cap rate is good because it means the worthiness of your premises will be higher.

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  • WACC = [E /(D + E)]*CAPM + [D /(D + E)]*DebtInterestRate*(1 – T)
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On the other hands, if you are buying a house then a higher cover rate is good since it means your preliminary investment will be lower. You could also be trying to find a market-based cap rate using recent sales of comparable properties. In this case, a good cover rate is one which comes from similar properties in the same location. For example, suppose you want to figure out what a working office building is well worth predicated on a market-derived cap rate. In this case, a good cap rate is one which is derived from recent office building sales in the same market. A negative cover rate would be one derived from different property types in various markets.

The cover rate is a very common and useful proportion in the commercial real estate industry and it can be helpful in several scenarios. For instance, it can and often is utilized to quickly size up an acquisition relative to other potential investment properties. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in an identical location should immediately let you know that one property has a higher risk premium than the other. Another way cover rates are a good idea is when they form a pattern.

If you’re taking a look at cap rate trends within the last couple of years in a particular sub-market then your trend can provide you a sign of where that market is going. For example, if cap rates are compressing that means beliefs are being bid up and the market is warming up. Where are beliefs likely to go next 12 months?