By: Isaac Dixon, Vice President of Portfolio Management at Canter Companies
What you need to know about Cap Rates
As the real estate market begins to stabilize in markets across the country, more and more people are beginning to explore investing in real estate once again. To effectively invest in real estate one must become comfortable with the terminology used in valuation techniques. Today I figured I would give a brief description of what a Cap Rate is and how it is used to value income producing real estate.
By Definition a Cap Rate is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. One common mistake is people use the property’s total revenue rather than its NOI (Net Operating Income) which includes all property level expenses other than debt service and depreciation (NOI= Revenue – Operating Expenses).
As an Example:
If your purchase a property for $100,000 and it earns $15,000/year Revenue but has $5,000 operating expenses (taxes, property maintenance, etc) your actual Cap Rate would be 10%, however the common error would be to use the higher revenue number giving you a 15% Cap Rate.
Correct Calculation: $10,000(NOI)/100,000(Purchase Price)= 10%(Cap Rate)
Incorrect Calculation: $15,000(Rev)/$100,000(Purchase Price)= 15% (Cap Rate)
Now that we have defined how to calculate a Cap Rate and its strict definition the real question is what does it mean to investors? The higher a Cap Rate the higher an investor can expect to earn from their investment. Usually the Cap Rate will also imply a bit about the market, in general the lower the Cap Rate the nicer the asset e.g. an ocean front duplex in La Jolla would have a much lower Cap Rate in comparison to a duplex located in Grant Hill.
Investors use Cap Rates in markets to allow them to compare similar income producing products. Analysts assign a Cap Rate to an area and then apply that number to properties NOI to ascertain a value.
While there are many other aspects to Cap Rates and their effects on real estate, one last point I would like to discuss is that a small adjustment in a Cap Rate will have an exponential affect on a property’s value.
As an Example:
An apartment building has an NOI of $200,000
Analyst 1 uses a 5% Cap to value properties in the area.
$200,000(NOI)/.05(Cap Rate) = $4,000,000(Asset Value)
Using Same example but Analyst 2 thinks 6% Cap Rates are appropriate for the market
$200,000(NOI)/.06(Cap Rate) = $3,333,333(Asset Value)
As you can see, a small move in the Cap Rate from 5% to 6% represents nearly $700,000 change in value.
Hopefully this gives you a little better idea of what a Cap Rate is and its effect on real estate valuation.
Find more helpful information on real estate terminology in our Real Estate Glossary.
About Isaac Dixon:
As the Vice President of Portfolio Management, Isaac oversees Canter Companies’ vast array of funds and investments. Formerly the Director of National Accounts for BGK Integrated Group (BIG) where he focused on developing and maintaining existing relationships within the independent broker-dealer community as well as identifying and cultivating new partnerships to add to BIG’s selling group. Isaac interfaced directly with the due diligence officers throughout the analysis, review, and approval process for real estate funds and Tenant-In-Common offerings. Additionally, Isaac has participated in several industry panels on various aspects of syndicating real estate investment programs and conducting proper due diligence. Prior to his career in national accounts, Isaac worked as a senior due diligence analyst at Independent Financial Group where he was responsible for reviewing over $500 million in Tenant-In-Common and alternative investment products. Isaac graduated from San Diego State University with a BS in finance. He holds or has held Series 7, 22, 24 and 66 licenses and is a licensed real estate broker in California.