# Cap Rate simplified

A cap rate (capitalization rate) is a term in commercial real estate that refers to the way a building is evaluated. It’s calculated by taking the net operating income, NOI, and dividing it by the cost of the building in order to give the rate of return (the term “return” may not be appropriate in all scenarios such as a building that is 100% financed).  Commercial Brokers frequently use this term in connection with the sale of investment real estate.

Capitalization rate = Net operating income / Cost of the building

The cap rate is a great unifying metric because it assumes the property is purchased in cash and not a loan, which can vary widely. It allows you to compare different buildings at a glance and quickly determine how the asking price is valued based on the rent.

The NOI is the annual income expected from rent minus the expenses for managing the property. This includes things like lawn maintenance and taxes, but not debt service.

The asset market value can be used in place of the cost of the building in determining the cap rate, if the building is not for sale. If the building was inherited for example, there is no building cost, so using the current asset value divided into the NOI will yield the most accurate cap rate.

Examples
Assume a building has an annual rent collection of \$120,000/year. The property has \$20,000 in maintenance expenses and taxes, leaving \$100,000 in NOI.

The building cost is \$1 million. The NOI of \$100,000 divided by the building cost of \$1 million is 10%. This means if the investor bought the building in cash, he could expect his return on investment to be 10% which is the same as a 10% cap rate.

\$100,000/\$1,000,000 = 10%

The cap rate is a better measure of value compared to ROI because the ROI is determined by the debt service, which can vary widely. Some banks lend 80% of the purchase price while others lend only 60%, and some investors will choose to purchase completely in cash.

The cap rate can be compared to riskiness. The riskier the investment, the higher the return investors will want to see. If there is a single mom and pop shop renting the building without a substantial personal guarantee, investors will want to get a higher return on the asset value, usually upwards of 10%.

If the tenant is a highly accredited national chain with a low chance of default, investors are willing to accept returns on the asset value as low as 5%.

Real estate comes with inherent risks and several other factors can lower the cap rate.  If there is a four tenant building generating \$100K in annual rent and two tenants move out, the annual rent collection could drop to \$50K (in the absence of a good Broker). Since property maintenance expenses will stay the same, this will have a severe negative impact on the cap rate. Sometimes these buildings make for attractive investments as the upside potential is high.  If the cap rate suffers too much from a loss of rent, the traditional land/improvement value may surpass the rental income value.

In another example, rent might stay the same but maintenance fees or taxes could increase, also adversely affecting the cap rate.

In another case, the asset value of the property could diminish, similar what happened in 2008, which would hurt the cap rate.

Generally speaking, as the seller of the building, the lower the cap rate the better. A \$100K NOI at a 5% cap rate yields a sale price of \$2 million, while a 10% cap rate yields a sale price of \$1 million.

However, in most cases, the cap rate will get better over time because the purchase price remains the same but leases have rent increases built into them. Over time, the rent increases faster than the expenses and the debt service, which is what makes real estate such an attractive investment.

If the building is purchased for \$1 million, the current annual rent is \$120,000, and there is a 3% annual rent increase, the cap rate will continue to improve for the owner.

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## transcript

Austin (00:32):

Hey guys, and welcome back to the podcast. It’s Austin here, and I’m here with Nate Palmer. And today we want to talk to you guys about a cap rate. This is a term that gets thrown around a lot in commercial real estate. And if you’ve ever looked at, you know, buying a building for yourself, or even sometimes renting it, it comes up. And if you don’t know what it is, it might sound confusing and the way that the math has done it takes a little bit of a learning curve to understand as well. So Nate, can you just explain to us a little bit about what cap rate is can rate?

Nate:

It is a mechanism that we use or really a term that we use in our business to identify or quickly understand the value of a property or the expectation of a value of a property.

And the calculation is pretty simple. It just assumes that that that rate is factored on the rate of return that you would receive if you paid all cash for the building. So if I’m expecting to collect a hundred thousand in annual net operating income, and I’m buying the property for a million dollars, the advertised cap rate would be 10%.

Austin:

Okay. So it’s just as the rate of return on the money, if you were to buy an all cash?

Nate:

Correct. And yeah, cause obviously you can, how you decide to finance the building is a question that varies, you know, depending on the person, depending on the institution. And so looking at your actual cash on cash ROI might be a little bit deceiving or at least hard to compare apples to apples and having a, it’s just a pretty much, it’s a broad rule of thumb that allows you to quickly compare buildings across the board equally with kind of understanding the same thing.

Austin:

So now that we’ve identified what it is, can you kind of talk about what will affect the cap rate?

Nate:

Yeah. Uh, great question, deserves more time than we’re going to give it, but if you boil it down on a real high level you know, there’s three or four characteristics that largely affect what those rates are. Um, and it’s term of the lease or term of the investment that I’m buying, or maybe a combination of value or of a number of terms. If I’m looking at a building that’s a multitenant, the credit of the user or, or users involved right in my buying something with a single practice operator, or am I buying something that the hospital’s leasing space and that’s basically just establishing a risk coefficient on that, on that rent expectation. And then, and then probably the third is, is the type of views, you know, fortunately in healthcare you know, we’re deemed to be pretty, pretty safe, pretty reliable ha has some different value there.

Then, you know, same credit financial sheet from you know, random shoe store operator or whatever it would be. So the type of use helps and then probably the fourth most important component would just be some of the deal characteristics. And there’s, you know, a hundred of variables that could fall into that category. But usually the initial main characteristics are going to be the term credit and the type of use.

Austin:

Okay. So, so, you know, talking about a 10% cap rate is really, it’s easy to understand. It’s easy to quantify because it’s relatively simple math, but let’s go through an example. You mentioned like a shoe repair might be on the higher cap rates. It would be about 10%, right?

Nate:

Yeah. I mean, you know, it could be, it could be anything you know, it’s just, it’s basically a balance of risk. If I’m going to give you a million dollars, how much I trust that you’re going to be there for five years, 10 years paying me the a hundred thousand dollars a year.

Austin:

Right. Okay. Yes. So in other way, I like to explain it is is in terms of risk and your investment as well. So if you’re going to make a riskier investment, then you’re gonna want a higher rate of return. So if the, the credit of the tenant in your building is not that great, then you are going to want to make sure that you’re getting a higher rate of return on your money to count for the risk. And 10% would be a very high rate and it would be really great as a buyer, you know, 10% cap rate is great. Now the lower that cap rate goes, it actually increases the price of the building, which I think is what’s so confusing for a lot of people.

And so, you know, if we are looking at a really accredited tenant, they have got, let’s say a 6% cap rate, then you’re going to be paying a much, much higher price for the building. So Nate, can you kind of explain that the math to help people understand that why as the cap rate goes down, the price of the building goes up?

Nate:

Yeah. I mean, they work they work in inverse so much to my example, if, if I have that same a hundred thousand dollar income stream that that I expect to collect after, after the property’s expenses. Uh, but instead of that user being a, what example is it, foot repairs, shoe repair store, instead of it being that I’ve got a, you know, a large physician group or a multi-practice group on the lease. And now, you know, maybe now the market value for that would be at a seven cap.

That \$100,000 income stream is now worth 1.4 million or a little better than that. So, you know, it’s basically, I’m exchanging the amount of risk I’m willing to take for the amount of return I’m willing to accept. Yeah. And the concept, when you think about it, it’s really simple when it’s explained correctly, but a lot of people struggle with this because the term gets thrown around so much.

Austin:

So yeah, if you are going to be making a hundred thousand dollars in operating income from this property, then you are willing to pay a lot more for that property. If the person who is paying it has a great credit rating. And you know, that if you ended up having to go after them in court, for whatever reason, they actually have assets, you can actually get the money. So that’s kind of what determines the cap rate.

So now what kind of cap rates are you seeing for healthcare operators? You know how does that vary depending on how many practices they have?

Nate:

Yeah. So that’s a great question. I mean, you can be anywhere from a single practice operator, if you’d commit to, I mean, it’s not a, it’s not a black and white issue because there, there are a handful of variables that significantly influenced this. But if we assume a term is equivalent and we’re looking at 10 year lease investment with a single opera, a single unit operator doctor, if he’s got some established history there, you know, maybe we’re somewhere in the nine cap rate ish plus or minus, maybe depending on the type of business, you know, some other, other characteristics start to, like I mentioned that fourth category, other characteristics start to come into play relative to, you know, how, how, how well the building’s positioned, what are my options.

If I were to ever lose that tenant, whatever that look would look like, the opposite end of that spectrum and say, Hey, I’ve got the opportunity to buy a building that has that same 10 year lease, except that’s with a hospital credit tenant where you know, that cap rate might be sub six, you know, and that arbitrage would be very significant in the property’s value, right? Yeah. Just the difference alone. If you’re, if you’ve got a million dollar property, you know, allegedly, if you’ve got a hundred thousand dollars in net operating income and it’s going for a 10 cap, then you’re going to be looking at a million dollars and as a sell price. Now just lowering that 1% to 9% cap rate increases the value of the building by \$111,000. So with each, it doesn’t sound like a lot, but each percentage point that you go down, you’re actually massively increasing the value of the building.

Austin (08:28):