Understanding Cap Rates
What is Cap Rate?
The capitalization rate (cap rate) measures a property's expected return as if purchased with all cash. It's the ratio of Net Operating Income (NOI) to property value:
Cap Rate = NOI ÷ Property Value
How to Use Cap Rate
- Valuation: Value = NOI ÷ Cap Rate
- Comparison: Compare similar properties in the same market
- Risk assessment: Higher cap = higher risk/return, lower cap = lower risk/return
What Affects Cap Rates?
- Location: Primary markets have lower caps than secondary/tertiary
- Property quality: Class A trades at lower caps than Class C
- Tenant quality: Credit tenants command lower caps
- Lease terms: Longer leases typically mean lower caps
- Interest rates: Cap rates generally move with interest rates
- Growth potential: Value-add properties may trade at higher caps
Limitations of Cap Rate
Cap rate is useful but has limitations:
- Ignores financing - doesn't reflect actual leveraged returns
- Point-in-time snapshot - doesn't capture growth or decline
- Depends on accurate NOI - garbage in, garbage out
- Not comparable across property types with different risk profiles