Capitalization rates, or “cap rates” for short, are one of the most widely used valuation methodologies in commercial real estate.

The calculation is fairly straightforward and allows both buyers and sellers to quickly evaluate the potential profitability of a purchase or sale. However, despite the apparent simplicity of the formula, many people don’t understand the limitations of relying on cap rates and can often end up using them to justify poor investment decisions.

What is a cap rate?

A cap rate is calculated by dividing the annual net operating income (NOI) by the price of the property.

Cap rate formula

Put simply, the cap rate represents a property’s expected yield in a one-year timeframe, based on the income it generates.

Cap rates are typically used to inform future purchases and sales, by projecting the market value of a property based upon its annual income. It also serves as a simple way to compare the relative value of two similar properties.

The higher the cap rate the lower the relative property value. Conversely, the lower the cap rate the higher the price for the property (this is assuming that NOI remains constant).

Watch this short video to find out more about on cap rates.

When can the cap rate be misleading?

While the math is relatively straightforward, determining the appropriate cap rate to apply to determine the value for a property at an unknown point in the future can be quite complex. By its nature, commercial real estate is highly illiquid and therefore sufficient sales data is not always available to determine the appropriate “market” cap rate to apply to a property.

Even when comparable sales data is available, it’s very difficult to find two properties that are truly apples to apples. In almost every circumstance, there are unique factors specific to every property that should be included in a thorough analysis of the potential value. In addition, changes in outside market forces can have a dramatic impact on what the true cap rate is for a property - this is particularly true when trying to forecast future cap rates based on a series of assumptions about what may or may not occur months or years down the road.

Financing not included!

It’s important to remember that NOI does not take into account the cost of financing and therefore the cap rate of a property may not accurately reflect the true risk-adjusted return potential of an asset that will ultimately be financed using some form of leverage (debt).

Because of the large impact that leverage can have on both the risk and potential return of any real estate investment, it may be more accurate to use other methods such as the cash-on-cash return or internal rate of return (IRR) when trying to evaluate a property’s value and/or investment potential.

Be wary of projections…

As we’ve discussed, cap rates can be viewed as a reflection of the premium demanded by the market to compensate for the perceived risk in any real estate investment. Given this information, when relying on cap rates as a way to make decisions, it’s important to keep in mind whether or not the cap rate is based on forward-looking projections.

No one can predict the future…and projections around future income always carry the risk that they don’t occur as anticipated. All too often, you see people trying to raise money or sell a property basing their values on future cap rate projections which in turn rely on extremely optimistic views of future events. This is of course no accident. An apartment building selling for a 5% cap rate may sound reasonable today but it may in fact be overly optimistic to assume that it will sell for that same 5% cap rate 10 years in the future.

While cap rates can be a very useful back-of the envelope way to quickly assess and compare the value of different real estate properties, it’s important to remember that cap rates may be limited in how much they can tell you about the overall quality of any property or real estate investment. As an investor, it’s important to recognize the difference between what the actual cap rate is of a property today versus what someone may be trying to convince you it will be in the future. Like all forward looking projections when it comes to real estate investments, the output is only as sound as the assumptions that are input into the formula.