In the simplest terms a cap rate is the way that commercial real estate is valued, measuring the risk vs. return for a given property. You can compare a property with a low cap rate to a savings account – in a savings account there is essentially no risk of losing the money you’ve deposited but the return in the form of interest is very low. In contrast, a high cap rate property is more like investing in stocks – the potential returns are much greater but there is a real risk of losing the initial investment.
In general, high cap rate properties generate more cash flow and are less expensive to purchase, whereas low cap rate real estate generates less cash flow and is more expensive to purchase.
Cap rates also act as a multiplier which help determine property value. Imagine a property with a Net Operating Income (NOI) of $100,000. The NOI is defined as the gross income minus the vacancy rate and all expenses associated with maintenance and operation, excluding mortgages (if any). By dividing the property’s NOI by the cap rate of the market, the result is the value of the property.
- $100,000 NOI in a 10-cap market, or 10% return: $100,000 is divided by 10% (.10), resulting in a property value of $1,000,000.
- The same property, with the same $100,000 NOI in a 5-cap market: $100,000 is divided by 5% (.05), resulting in a property value of $2,000,000.
The same property, generating the same NOI, is valued differently based on the market and the associated cap rate. Since the cap rate acts as a multiplier on the NOI, every dollar the NOI for a property increases (for example by increasing rents or decreasing expenses) is multiplied by the cap rate percentage. With a 10-cap market, every extra dollar of NOI is divided by 10%, therefore adding an extra $10 of property value. In a 5-cap market, each extra dollar of NOI is divided by 20%, adding $20 of property value. Leveraging this multiplier effect at the right time is an important way that real estate investors can generate returns on their investments.
As a final note, familiarity with cap rates and how to use them to make money is a concept which carries over into other forms of investing outside of real estate and is very much worth taking the time to learn.