“Tell me about cap rates.”
“Well, it’s your net operating income divided by the purchase price.”
In my head, I was repeating: Low cap rate means high purchase price. High cap rate means low purchase price.
This was during a job interview for my first position in real estate development. For some reason or another, I got the job. Maybe it was because I answered the cap rate question confidently. I don’t know.
But I quickly learned that cap rates are one of those terms you hear a lot in commercial real estate.
For readers who are new to the topic, capitalization rates—or cap rates—give us a quick way to compare a property’s income to its value.
Generally, a higher cap rate means more income relative to the purchase price, while a lower cap rate means less income relative to the purchase price.
The calculation is simple:
Cap Rate = Net Operating Income ÷ Property Value
If a property generates $50,000 per year in net operating income (NOI) and is worth $1 million, the cap rate is 5%.
Simple enough.
If you’re new to cap rates, check out our Cap Rate Calculator. You can plug in some numbers and see how NOI, property value and cap rates relate to one another.
Why Do We Talk About Cap Rates So Much?
Partly because they’re useful.
Once you understand the concept, a cap rate gives you a very quick way to talk about the relationship between a property’s income and its value. It’s often one of the first numbers people ask about when an income-producing property sells.
And maybe, throwing around terms like cap rate makes brokers feel a little smarter when talking about real estate. Maybe.
There are a couple problems that come up when referencing cap rates.
The problem isn’t the metric itself.
The problem is when we ask a simple metric to tell us the whole story.
“You Sold It at a 5 Cap?”
I remember a property our company sold where someone heard the transaction worked out to roughly a 5% cap rate.
Their reaction was immediate:
“A 5 cap? You guys got worked over. The market‘s 4.5 easy.”
I understood what they were thinking. If the property had sold at a lower cap rate, all else being equal, the purchase price would have been higher.
But I also knew they were putting too much weight on one number.
There was more going on with the property than its current income.
In this case, the purchaser was taking on significant capital work after the acquisition. That meant additional cost and risk, which affected what they were willing to pay. If they didn’t have to do this work, then sure, the price would have been higher (meaning a lower cap rate).
Simply comparing the transaction’s cap rate to a “market rate” misses important aspects of a deal.
There are many other examples of this.
A property could have upcoming capital costs. Lease issues. Poor tenants. Environmental concerns. Or any number of other factors affecting what someone is willing to pay.
The takeaway is simple: don’t put more weight on a cap rate than it deserves.
A property purchased at a high cap rate might be a great deal.
Or it might not be.
The cap rate alone won’t tell you.
It Works the Other Way Too
On another transaction, someone thought the purchaser had dramatically overpaid because the purchase price represented a cap rate of around 2%. This was well below what you might normally expect for that type of income-producing property.
If you only looked at the cap rate, you could understand the conclusion. Low cap rate (relatively) means a high purchase price. Did they pay too much?
But the purchaser wasn’t really buying this property for its existing income.
They were buying the development opportunity.
Their valuation was based on what they believed could ultimately be developed on the site, what that development would be worth, and what it would cost to get there.
Judging that acquisition solely by its cap rate based on existing income on the property would completely miss the purchaser’s investment thesis.
A Metric, Not the Full Answer
None of this means cap rates aren’t useful.
They are.
They provide a quick way to understand the relationship between income and value. They can help compare similar properties, provide a high-level check against other transactions, and help estimate property value based on expected NOI.
I absolutely think you should bring them up at real estate cocktail parties and maybe even a job interview.
But they need context.
Two properties producing the same income aren’t necessarily worth the same amount.
One might require significant capital improvements. One might have substantial redevelopment potential. One might have excellent long-term tenants. One might be in the middle of nowhere.
The cap rate doesn’t capture all of that.
That’s really the lesson for us here:
Cap rates are a useful lens for looking at a property. They aren’t a substitute for understanding the property.
So when you hear that a building sold at a 4%, 5% or 6% cap, don’t stop there.
Ask what’s behind the number.
Unless of course you’re trying to give your buddy a hard time about the property they bought. Then, by all means, tell them they overpaid.
Again, if cap rates are a new concept for you, or you want to see how changes in NOI, purchase price and cap rates affect value, check out our Cap Rate Calculator for a more detailed explanation and a chance to run the numbers yourself.
Playing around with the numbers can be a great way for this concept to sink in.
Could You Benefit From Real Estate Development Guidance?
If you’re considering developing a property and need help understanding its potential, SiteMentor Development Consultants can help assess your development options, identify key risks, review the financial viability and provide greater clarity before you move forward.
