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What you should know about the cap rate

The capitalization rate is a fundamental concept in the commercial property industry, yet it is often one of the most misused and misunderstood.

Cap Rate Definition

What is a cap rate? The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for R1,000,000 and generated an NOI of R100,000, then the cap rate would be R100,000/R1,000,000, or 10%. I.E. Cap rate = Annual Net Operating Income / Cost and is expressed as a percentage

Cap Rate Example

Let’s take an example of how a cap rate is commonly used. Suppose you are researching the recent sale of a warehouse building with a stabilized Net Operating Income (NOI) of R1,000,000, and a sale price of R17,000,000, it is common to say that this property sold at a 5.8% cap rate.

Intuition Behind the Cap Rate

What is the cap rate actually telling you?  One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase.  In the above example, an all cash investment of R17,000,000 would produce an annual return on investment of 5.8%. 

As shown above, cap rates and price/earnings multiples are inversely related.  In other words, as the cap rate goes up, the valuation multiple goes down.

When, and When Not, to Use a Cap Rate

The cap rate is a very common and useful ratio in the industrial and commercial real estate industry and it can be helpful in several scenarios.  For example, it can and often is used 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 a similar location should immediately tell you that one property has a higher risk premium than the other.Another way cap rates can be helpful is when they form a trend.  If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed.  For instance, if cap rates are compressing that means values are being bid up and a market is heating up.  Looking at historical cap rate data can also quickly give you an insight into the direction of valuations.

Cap rates are useful for quick back of the envelope calculations, but ultimately the cap rate itself is subjective and its use must depend on your own business judgement and experience. Many factors can influence the value of an investment property both up and down. Some of the most important include future maintenance; security of the income stream (strength of the tenants and length of the leases); comparable sales in the area; general economic and market conditions; and the local market.


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