What Does Capitalization Rate (Cap Rate) Mean?
The capitalization rate or "cap rate" is used in real estate to determine the value of an income producing real estate property. This is done by taking net operating income (NOI) and dividing it by the capitalization rate.
Suppose you have a property that generates net operating income of $100,000. If the cap rate for this property is 10%, then the property value would be $1,000,000 ($100,000/10%). The NOI multiplier would be 10X, and the cap rate would be the inverse of this multiplier. Therefore, the cap rate and the value of the property are inversely related. This means the lower the capitalization rate used to value a property, the higher its value will be.
Divestopedia Explains Capitalization Rate (Cap Rate)
There are many factors that influence the calculation of the cap rate and, ultimately, its calculation is part science and part art. There are many other qualitative factors that influence the quality of the future income stream that need to be considered such as:
- The type of property and location - Different types of properties (i.e. industrial, retail, or residential) have different cap rates due to their various levels of risk. An industrial property may have only one tenant whereas a residential property may have multiple tenants mitigating the loss of income if there is some vacancy. The location also impacts the cap rate as more desirable locations in a city will drive higher real estate values as people are willing to pay more for their income streams (they see less risk of loss in the income stream) and, therefore, drive the cap rate down.
- The structure of the real estate transaction - A buyer may be willing to pay more for a property if the seller is willing to offer high vendor take back financing that is interest only for a longer term than the norm. Therefore, the cap rate on this transaction would be lower but not necessarily indicative of a more conventional structure for a transaction.
- Any "pop" in future income - If the leases are coming due and they are below market or the residential rental market is heating up, then you have a potential future pop in your NOI. Hypothetically, a buyer should pay a higher value for this property (a lower cap rate) because the income will increase.
- Physical condition of the property - If the property has significant deferred maintenance, such as a roof that needs to be repaired, a buyer will push for a higher cap rate. The buyer may want to hire a contractor to review the condition of the property during due diligence to assess and quantify all maintenance issues. Then the buyer will likely bring up the total repair dollars required to negotiate a higher cap rate on the property.
- How good the tenants are and how long their leases are - If the property has a number of poor or similar tenants, then you have considerably higher risk of vacancy which may result in a higher cap rate.
- Vacancies - If the vacancy is higher than average and it is not due to a specific circumstance (i.e. building improvements), then it may simply be that this tenant mix or property is below average, which would result in a higher cap rate being applied.
When computing the cap rate, remember that benchmark transactions are simply the starting point. Each property is unique and what a buyer will try to determine is the risk of future vacancy resulting in lower NOI. This risk will dictate which cap rate is most applicable to the specific property.