Cap Rate (Real Estate)

“Cap Rate” is the commonly used abbreviation for “capitalization rate”. The cap rate expresses the percentage based yield of a real estate investment.

The cap rate formula is fundamentally simple:

Cap Rate = Net operating income (NOI) / Acquisition cost

There is however scope for investors to get different results, even when looking at the same investment.  People may define NOI differently, and may choose to include or exclude certain expenses to/from their purchase cost. The formula can also be modified to consider the current market value of the property (FMV), instead of the acquisition cost.

The cap rate is a short-hand approach to quickly calculating the yield of a cash-flowing property. Its depth is limited as it does not consider two major factors that will determine the outcome of a real estate investment: capital appreciation or loss realized upon sale and cash-flow variance as a result of expenses and vacancy.

The cap rate expresses the yield on investment, but can also be used to determine an acquisition price for a property whereby an investor has a known cap rate requirement.

Mr. Client acquires a commercial property in his home town. It is currently rented out to a dental clinic.

Sales Price: 1,200,000 USD
Misc. acquisition costs: 36,000 USD
Net monthly cash-flow: 5,500 USD

Cap Rate = (5,500 x 12 months) / (1,200,000USD + 36,000) X 100 = 5.33%

In an alternative scenario where Mr. Client is going to buy the property again, If Mr. client knew that the property was producing 5,500 USD per month in net monthly cash flow, and he wanted it to ‘cap’ at 6% he could work out his maximum acquisition expense that would still give him an annual return of 6%:

(5,500 x 12) / 0.06 cap = 1,100,000 USD