What is a CAP rate?

Robert Cooper, October 8, 2021

 

What it is

One of the first acronyms that new commercial real estate investors are confronted with is something called a CAP rate. The first time they encounter it usually leaves investors scratching their heads, followed by saying to themselves, or outloud, What is a CAP Rate? And that question brings us here.

 

The CAP rate (short for capitalization rate) is a ratio. It’s math, but don’t freak out all of you Liberal Arts folks, it’s simple and straightforward. Here it is…you take the net operating income of the property (aka NOI, and to be explained in a future BLOG) and you divide it by the purchase price (or value) of the property. Here’s an example

 

The net operating income for the recent year was $1,000,000
The price of the property is $20,000,000
The CAP rate is 1,000,000/20,000,000 = .05, or 5%

So the CAP rate expresses the return (in this case 5%) of your investment (assuming you paid all cash for the property).

What is the use of the CAP rate?

The CAP rate is a tool to compare investments. The higher the CAP rate, the more profitable the investment, all else being equal. So if you’re choosing between two investments and one investment has a CAP rate of 10%, and another has a CAP rate of 5%, then the 10% return is more attractive than the 5% return.

It’s similar to the PE ratio used in stock ratings

If you have knowledge of or experience with how stocks are measured then you have heard of the PE (price to earnings) ratio. Here is an example:

Price of a share of ABCcorp stock: $20
Earnings per share of ABCcorp stock: $1
The PE ratio is 20/1 = 20.

This example can be interpreted to mean that if these earning were to continue to be the same each year then it will take 20 years to recoup your investment (assuming these are annual earnings).

So the CAP rate (earnings divided by price) is the inverse of the PE ratio (price divided by earnings). So, if you are more comfortable with a PE ratio you can convert the CAP rate to it by simply dividing it into.  Following our CAP rate example above that would be 1/.05 = 20.

Hopefully this has answered the question of what is the CAP rate for you. Of course the CAP rate is only one tool used in the evaluation of commercial property. There are many other considerations to consider during an analysis of commercial real estate investments which we will ultimately address over time on this blog.