What is a Cap Rate?
Capitalization rate, commonly referred to as cap rate, is a financial metric used to measure the expected rate of return on an investment property. It is also a standard valuation tool that helps investors determine the value of a property based on the property’s NOI.
Cap rates are important in determining the value of a property and comparing different investment opportunities. They are used as a price evaluation tool when entering and exiting an investment.
Cap Rate Calculation Example
To calculate a cap rate, divide the NOI by the property’s current market value. The formula is expressed as cap rate = NOI / Property Value.
Let’s say you own a rental property that generates $100,000 in annual net operating income (NOI), and the current market value is $1,000,000.
To calculate the cap rate, you would divide the NOI by the property value:
Cap Rate = NOI / Property Value
Cap Rate = $100,000 / $1,000,000
Cap Rate = 0.10 or 10%
So in this example, the cap rate is 10%. This means that for every dollar you have invested in the property, you can expect to earn a 10% return based on the property’s net operating income.
Cap Rates in Valuation
Market cap rates can be used to estimate a property’s value. To use market cap rates to evaluate a property’s value, we first determine its NOI. Next, we determine the appropriate current (or projected) market cap rate. With this information, divide the property’s NOI by the market cap rate to estimate its value.
For example, if a property generates an NOI of $100,000 and the market cap rate is 6%, the estimated value of the property would be $1,666,667 (i.e., $100,000 divided by 0.06).
It’s important to note that market cap rates can vary based on location, property type, and market conditions. Therefore, it’s essential to do thorough research and analysis to ensure the estimated value is as accurate as possible.
While cap rate is a valuable metric for individual investors, when investing in a syndication, this is a metric that investors don’t necessarily need to worry about directly. The general partners handle the property acquisition and cap rate analysis, while limited partner investors benefit from an entirely passive investing experience.