3 Reasons Real Estate Investors Need To Understand “CAP Rates”
As an investor you will want to capitalize the income of a property to determine its investment value, understand the investment performance at a purchase price, and disposition of the asset.
The Certified Commercial Investment Member defines the cap rate as such: “A percentage that relates the value of an income-producing property to its future income, expressed as net operating income divided by purchase price. Also known as cap rate.”
You will need to understand three components of direct capitalization: Income (NOI), cap rate, and value. If you have two of the three then you can solve for the third.
The net operating income (NOI) is potential rental income minus vacancy, credit loss, and operating expenses. You will use the NOI to pay your debt service (if any) and your capital expenditures (some choose to put it above the NOI).
Lets assume we are working with a $1,000,000 property that produces an NOI of $100k. (Gross income of 200k minus 100k of expenses = 100k NOI)
Cap rate related formulas:
- CAP Rate = NOI / Value (100k/1m=10%)
- NOI = CAP Rate x Value (.10x1m=100k)
- Value = NOI / CAP Rate (100k/.10=1m)
3 Reasons You Need To Understand Cap Rates:
1) You will use the cap rate to measure the investment performance of an asset at its purchase price. Be careful as this only considers the rate at the time of purchase, not how you will operate the property after receiving ownership.
2) For investment value. This will show you the purchase price of the asset based on the NOI and given cap rate of the market. You then have to decide if it fits your investing criteria over a given hold period so you can measure your return or yield.
3) For disposition of the asset. To measure your yield over the holding period, you will want to predict the disposition cap rate. Or simply put, what cap rate the building will sell at to determine sales proceeds. If you decide to hold onto the property for 5 years, then you will want to divide the projected 6th years NOI by the projected market cap rate to determine what the next investor will purchase the property for.
- The cap rate is a ratio of purchase price and the first year NOI
- It’s a good quick measure for comparison of similar assets and what they sold for
- Very simple measure, but the simplicity limits dependability
- It is a process to determine the value of your investment, but not your return on investment
- Does not take into account sales proceeds (yield does)