The Capitalization Rate, better known as the “Cap Rate,” is arguably one of the most fundamental concepts in real estate investing, but often the most widely misunderstood.​ A cap rate measures a property’s natural rate of return for a single year without taking into account debt on the asset, making it easy to compare the relative value of one property to another.

How to Calculate a Cap Rate

For those who are familiar with finance but new to real estate, think of a cap rate as the reverse of the price-earnings ratio (“P/E”) used in the stock market. While the P/E ratio measures the price, or market value, of a stock divided by its earnings per share, the cap rate measures the annual income of a property, divided by its cost, or value.

Cap rate formula

What does the cap rate tell us?

Put simply, cap rate measures a property’s yield in a one-year time frame. This makes it easy to compare one property’s cash flow to another – without taking into account any debt on the asset. In short, it provides the property’s natural, unlevered rate of return.

Another way to think about it as a measure of risk in the deal. What return would you expect given the risk of the specific property or asset? Everything else being equal, properties that are older and have fewer credit-worthy tenants, for example, may have more risk, and therefore would be lower in price, resulting in a higher cap rate. Diversity of the tenants, length of leases in place, condition of the property, and location may also contribute to the risk premium and therefore impact the property’s value and subsequently its cap rate.

When are cap rates used?

Given the relatively complex, illiquid nature of commercial real estate, valuations can at times seem hard to calculate. Cap rates help provide a comparative tool to look at potential investment properties on a more apples-to-apples basis. Both buyers and sellers rely on cap rates consistently to evaluate fair pricing and decipher trends in a given market.

Cap Rates in Action

Let’s pretend we are evaluating an investment in a project that costs $10 million and has an annual Net Operating Income (NOI) of $700,000.

Cap rate 7 percent

What does this mean? On its own, not much.

Let’s now say that the building next door has the same square footage, and is relatively similar, but is only generating $300,000 in NOI for the same $10 million price.

Cap rate 3 percent

Which one would you want to buy? Hopefully you’d say the first. You can learn more about what constitutes a “good” cap rate here.

The cap rate of a property will fluctuate if either the NOI or value changes. Since a property’s value can be impacted by many outside forces such as market demand or interest rates, the cap rate for a single property may go up or down even if there is no physical change to the amount of income (NOI) produced.

When Should You Avoid Using Cap Rates?

Cap rates represent an important valuation tool when used appropriately. However, the cap rate alone should never be used as the sole deciding factor in making an investment, and it’s important to note that in some cases cap rates don’t apply. For example, cap rates are not useful for evaluating fix-and-flips and other short- term investments where the ultimate objective is to exit quickly via sale. These types of investments do not generate income from rent and therefore cannot be measured on a cap rate basis.

Investors should also be aware that the cap rate is not the same as the cash-on-cash return, which is determined by the amount of cash flow after paying any debt service or mortgage payments divided by the total amount of cash invested. While both may be useful in evaluating the potential profitability of an investment, cash-on-cash takes in account debt on the property while the cap rate does not.

Cap Rates in Today’s Economy

In today’s low interest rate environment, cap rates for commercial real estate properties are at all-time lows for almost every asset class. This low interest rate environment is due primarily to the Federal Reserve’s policy decisions, not necessarily market-driven forces. Since the collapse of 2008 we’ve seen an unprecedented run up in real estate values across the US, particularly in markets like New York and San Francisco, where cap rates are now in the low single digits. With cap rates this low, property values are at an all-time high, making it challenging to find new investment opportunities at what many would consider a good relative value.

Conclusion

Given the current macro-economic environment, it’s more important than ever for investors to understand both the benefits and drawbacks of using cap rates to determine which investment opportunities warrant a closer look, and which are simply overpriced relative to market comparables.