Monday, December 17, 2007

What is a CAP Rate?

Capitalization Rate Blog Entry By Triple Net Leased Investment Expert Jess Biggs

A cap rate is determined by dividing the net operating income of an investment by its value:

CAP RATE= Net Operating Income (Cash Flow) / Value (Purchase Price)

As a commercial real estate agent specializing in triple net leased investments, the first thing my investor clients usually ask about is the CAP rate. Determining the CAP rate on a potential commercial investment is a key element in analyzing “the deal”.

Why is this calculation so important, and exactly how does it work?

CAP rate, short for capitalization rate, is the most common measure commercial real estate investors use to evaluate the return of invested capital on improved land that is producing a stream of income. This rate represents the recapture yield of invested funds to the investor on an improvement through the end of its economic life. Capitalization is a term appraisers use when they use the income approach to evaluate the value of a property based on the cash flow the property produces or could produce. Thus, capitalization “is a mathematical process for converting net income into an indication of value” (The Language of Real Estate, 5th Edition, by John W. Reilly).

I have heard clients ask their brokers to determine the CAP rate as though they had to someway “divine” it. In actuality, determining the CAP rate is not hard to do, and doesn’t take any supernatural ability or insight to do so. No banker, lender, appraiser, or high-end CPA must provide you with secret knowledge or insight to determine this rate. Actually, anyone can easily find a CAP rate with minimum math skills and a scrap piece of paper or $3 calculator.

To start, determine the property’s gross rental income, from which you will subtract operational expenses to get to the pre-tax net operating income, referred to as NOI. You are probably wondering which operational expenses should be subtracted to get to this NOI number. This is where the CAP rate can be adjusted somewhat to manipulate the attractiveness of the investment property’s rate. Such expenses or deductions could include management fees, vacancy losses, property taxes, insurance, and maintenance costs, along with a few other possible deductions depending on the situation.

Thus, it is very important when evaluating a CAP rate to know what expenses or deductions were first subtracted from gross income to determine the NOI. It is also important to determine what exactly makes up income as well, since income might be calculated for just the current year, or it may allow for future rent increases and expenses also. Ultimately, however, the NOI number represents a pre-tax cash flow which represents the income amount the investor will receive from the property and can fluctuate up or down depending on what numbers it is calculated from. An outline of how to calculate NOI can be found in the formula below:

Potential Gross Income
Less: Vacancies
Less: Bad Debt/Credit Losses
= Adjusted/Effective Gross Income
Less: Operating Expenses
= Net Operating Income (NOI)

By now you are probably wondering how this NOI number determines the CAP rate. Here’s how. For example, if you have a $120,000 investment that was returning $12,000 to you in income, then your rate of return would be 10% ($120,000/$12,000=10%) by dividing the estimated or approximate purchase price (value) of the property by its rental NOI income.

Thus, an easy way to remember how to find the CAP rate, purchase price value, or income for a commercial investment opportunity is to use the IRV format, shown in the illustration below. To use this memory device, just remember that you only need two of the numbers to find the third; value and rate can be multiplied together to find the income, and income can be divided by rate or value to find the other one that is needed.

Because the level or risk is equal to the CAP rate, the higher the risk involved in a certain investment, the higher the CAP rate will be, and vice versa. There are also other factors that tend to move with CAP rates as well. For example, as interest rates in the market increase, CAP rates will follow, and vice versa. Conversely, as appreciation and demand increases in the marketplace for similar investments, CAP rates will fall since the level of risk falls for those types of properties.

The final thing to remember is that CAP rates have an inverse relationship with its counterpart numbers, income and value. For example, as the CAP rate increase, the purchase price (value) will fall, and vice versa. Fluctuating income will also affect the rate as well.

NAI Commerce One is not a licensed CPA, certified mortgage broker, or certified financial planner and is not providing this information for professional consulting services. All blog posts are only for educational and informational purposes only, and should not be construed as suggestions or recommendations on as to how viewers of this information should practice commercial real estate investing in their individual financial affairs.


mark said...

Great article on the real estate happenings, I really enjoy reading your posts. Just for your information, Donald Trump is in big trouble right now with his real estate empire. I hope everyone can pull through this slump!!


Real Estate Professional

John beck said...

I think it’s especially true in Real Estate for the “Buyer to Beware” A realtor has nothing to lose, and a whole lotta

commission to gain.Do your homework, ask tough questions, and don’t feel rushed into doing anything!

Randy said...

Great article! Jess is a very knowledgeable person.

Randy said...

Great article! Jess is a very knowledgeable person.