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The capitalization rate, also known as cap rate, is arguably one of the most important metrics in commercial real estate. It’s also one of the most frequently misunderstood and misapplied. Today, we’re going to clear the air a bit.
We’ll explain what your cap rate is, how to calculate it, why it’s important, when you should use it, and what other metrics should be applied alongside it.
Cap rate is generally used to determine a property’s growth rate, also known as its rate of return, over a predefined period of time.
For example, let’s say someone purchases an apartment complex for $5.5 million and they want to determine how much of their investment they will recoup on a yearly basis. They’d use cap rate to determine it based on how much revenue the property generates.
Depending on how much depth you want to go into, there are a few different ways you might calculate the cap rate of a property. We’ll start with the simplest. First, you’ll want to determine your property’s total Net Operating Income by adding up your total pre-tax revenue and subtracting required operating expenses over your specified time period.
Next, divide your net operating income by your property’s current market value, then multiply that number by 100. This will provide you with a percentage-based metric. There are a few reasons it’s recommended that you use the market value rather than your purchase price, as explained by the investment website Investopedia.
First, it’s because using your purchase price can leave you with unrealistic results if you bought the property several years or decades ago. It also cannot be applied to properties you’ve inherited, because their purchase price is technically zero. Finally, given that the real estate market can be somewhat volatile, property values tend to fluctuate wildly year over year.
Let’s go with our earlier example of the apartment building. For simplicity’s sake, we’ll assume the new owner is able to rent out each unit in the building for two thousand dollars a month, and there are thirty units in the building. For each year, the owner would add up the total rent gained from the units, fewer maintenance expenses, water, and fees paid to their management company.
Here’s where things get a bit complicated. There’s really no way of differentiating between a good capitalization rate and a bad one. This is because cap rates don’t exist in a vacuum but instead are predicated on multiple factors and variables.
These might include the following:
Also known as the Dividend Discount Model, the Gordon Growth Model is a slightly more complicated formula for calculating the cap rate. This is because it allows you to account for NOI growth over time, and determine a general valuation of your property beyond its market price. As such, it incorporates a few additional metrics, specifically discount rate and constant growth rate.
Let’s go back to our apartment example. We’ll assume the discount rate (the investor’s required rate of return) is ten percent. Given our previous calculations, we’re already above that, so we’re in a pretty good spot.
Assuming a growth rate of two percent annually, we can enter the following calculation:
$597,600/(10%-2%) = $6,790,909
Note that the Gordon model doesn’t work for properties where the growth rate and discount rate are identical. It also doesn’t really account for variable market growth. As such, just like the simpler cap rate formula, it has a relatively narrow set of applications.
The best time to use cap rate as a metric is when you’re trying to decide between several different properties or trying to determine your return on an investment you purchased at market price. Going back to our example of the apartment building, let’s say that instead of buying at market price the owner got a great deal on it at a bank auction and acquired it for $2 million.
Because they paid significantly less than the property’s value, they cannot use the cap rate to determine their rate of return.