The cap rate formula is an invaluable tool for commercial real estate investors. It’s not just another financial term but a critical yardstick that measures the potential return on investment and compares diverse properties.
At its core, the cap rate formula is a straightforward equation that evaluates the profitability of an investment property. The cap rate simply divides the property’s net operating income by its current market value.
A higher cap rate often signifies greater risk, yet it also indicates a potential for higher returns. However, it’s worth noting that this formula is only a partial solution, part of a broader toolkit for assessing real estate investments.
This article will guide you through the ins and outs of the cap rate formula, its practical applications, and its significance in making informed decisions in commercial real estate. After reading, you’ll be better able to transform complex choices into strategic moves that bolster your real estate portfolio.
What is the Cap Rate Formula?
The cap rate formula is an essential tool that allows investors to evaluate and compare the risk and return profiles of similar properties in the same asset class and geographic area in a standardized way.
This formula serves as an indicator of potential returns on an investment, providing a snapshot of a property’s profitability without factoring in mortgage financing by measuring the ratio of the property’s Net Operating Income (NOI) to its current market value:
- Cap Rate = Net Operating Income / Purchase Price or Current Market Value
How to Calculate Cap Rate
Calculating the cap rate of a property is a straightforward process that involves two key components: the Net Operating Income (NOI) and the current market value of the property.
- Identify the Net Operating Income (NOI): The NOI is the annual income the property generates after deducting all operational expenses from the gross annual income. It does not include any mortgage payments or financing costs. For our example, we’re considering a multifamily property that generates an NOI of $300,000 per year.
- Determine the Current Market Value: This is the price at which the property would likely sell in the current market. In our example, the multifamily property is valued at $5 million.
- Apply the Cap Rate Formula: Once you have these two figures, you can calculate the cap rate using the formula: Cap Rate = Net Operating Income / Current Market Value and plugging in the numbers from our example: Cap Rate = $300,000 / $5,000,000.
This calculation yields a cap rate of 0.06, or 6%. If the property operates as it currently does and the market conditions remain consistent, an investor could expect a 6% return each year before mortgage payments or financing costs.
Once you have the NOI, divide it by the property’s purchase price (or value). This will give you the cap rate as a percentage.
For example, let’s say you’re looking at a commercial office building with an annual gross income of $1 million. After subtracting all the necessary expenses for owning and operating the property, you’re left with an NOI of $500,000. If you’re looking at purchasing this property for $8 million, your calculation will look like this:
- Cap Rate = $500,000 / $8 million = .0625 x 100 = 6.25%
What is a Good Cap Rate?
Determining a “good” cap rate is subjective and relies heavily on an investor’s goals, risk tolerance, and investment strategy.
For instance, if an investor prioritizes income stability and lower risk, a property with a lower cap rate might be more attractive. This is because properties with lower cap rates are often located in established markets with high demand, leading to more predictable income streams.
Conversely, investors seeking higher returns and willing to assume more risk might be drawn to properties with higher cap rates. These properties are typically found in emerging markets or areas with lower demand, hence the increased risk but also the potential for substantial returns.
It’s crucial to remember that the cap rate is just one piece of the investment puzzle. Other critical financial metrics, such as the cash-on-cash return — which measures the annual return the investor can expect based on the cash invested — and the internal rate of return (IRR) — which provides a more comprehensive view of the potential profitability of an investment over its entire lifecycle — should also factor into the decision-making process.
Cap Rate vs. Cash-on-Cash Return
As discussed earlier, the cap rate provides a snapshot of a property’s potential return based on its income and market value. It does not consider financing methods or mortgage payments.
On the other hand, cash-on-cash return considers the actual cash an investor has put into the property, making it particularly useful when properties are financed. The formula for calculating cash-on-cash return is:
- Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
Continuing with our multifamily property example, recall that the cap rate was 6%. Suppose the investor decides to finance the property purchase with a mortgage instead of buying it outright. Assume that the investor secures a mortgage with a down payment of 25% of the property’s market value, which is $1.25 million ($5 million * 0.25).
In this example, after paying all operating expenses and the mortgage, the annual pre-tax cash flow from the property is $100,000. Applying the formula for cash-on-cash return gives us:
- Cash-on-Cash Return = $100,000 / $1,250,000, which yields a cash-on-cash return of 0.08, or 8%
In this scenario, the cash-on-cash return of 8% is higher than the cap rate of 6%. Both are measures of return, but they focus on different things. The cap rate focuses on the overall profitability of a property, while cash-on-cash return concentrates specifically on the cash flow that an investor sees each year.
Cap Rate vs. IRR
Cap rate is a snapshot of a property’s potential return based on its income and market value without considering mortgage financing. It also does not factor in financing or the timing of cash flows.
The Internal Rate of Return (IRR) is a more comprehensive metric that accounts for the time value of money, acknowledging that a dollar today is worth more than a dollar in the future due to its potential earning capacity.
The formula for calculating IRR is a bit complex as it involves solving for ‘r’ in the equation:
- NPV = ∑ [CFt / (1+r)^t] – Initial Investment
Where NPV is the net present value, CFt is the net cash inflow during the period t, r is the rate of return, and t is the number of time periods, such as a year. IRR provides an annualized rate of return based on the timing of the cash flows.
To illustrate this, let’s consider two different properties, Property A and Property B. Both properties are expected to generate $100,000 in net income over the next five years. However, Property A will generate that income evenly over the five years, while Property B will generate most of its revenue in Year 5.
If you only look at cap rates, you might conclude that both properties are equally good investments since they generate the same net income. However, when you calculate the IRR, you’ll find that Property A has a higher IRR because it provides a return earlier. This example highlights that cash received sooner is more valuable because it can be reinvested to generate additional income.
While cap rate can provide a quick and easy way to compare potential returns on different properties, IRR offers a more nuanced view, considering the timing of cash flows and the time value of money.
Investors should ideally consider both metrics and others like cash-on-cash return when evaluating real estate investment opportunities.
The Multifaceted Approach to CRE Investments
In conclusion, while the cap rate is valuable in assessing commercial real estate investments, it’s not the be-all and end-all. It provides an initial glimpse into the potential profitability of a property but doesn’t factor in financing methods or the time value of money.
For a more holistic overview of an investment’s prospective returns, investors should consider other metrics, such as the cash-on-cash return and the Internal Rate of Return (IRR). By understanding and employing these varied metrics, investors can make well-informed decisions, ensuring their robust and diversified investment portfolio.
Ready to get started investing? Learn more about your next asset with cap rate data and other insights from Crexi Intelligence.
Frequently Asked Questions
Is cap rate the same as ROI?
No, cap rate and Return on Investment (ROI) are different real estate investment analysis metrics. Cap rate is a measure that shows the potential rate of return on a real estate investment based on the income the property is expected to generate. Conversely, ROI is a more general measure used in finance that calculates the percentage return on an investment relative to the investment’s cost.
Why is a lower cap rate better?
A lower cap rate isn’t necessarily better. The cap rate can be seen as the risk premium for investing in a property. A higher cap rate may indicate a higher risk associated with the investment (and thus a higher potential return). In comparison, a lower cap rate suggests lower risk (and hence lower potential returns). Therefore, whether a high or low cap rate is ‘better’ depends on an investor’s risk tolerance and investment strategy.
How does the time value of money affect the cap rate?
The cap rate doesn’t directly consider the time value of money. It’s a static metric that provides an instantaneous snapshot of a property’s potential return based on its net operating income and market value. On the other hand, metrics like the Internal Rate of Return (IRR) do consider the time value of money, providing a more comprehensive view of an investment’s potential over time.
Can you use cap rate and IRR together to analyze an investment?
Absolutely! It’s beneficial to use both these metrics together when analyzing a potential investment. While the cap rate can give you a quick snapshot of a property’s earning potential, the IRR provides a more in-depth look by considering the timing of cash flows and the time value of money. By using both, you can gain a well-rounded understanding of a property’s potential profitability.