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Real Estate 101 - What's a Cap Rate?

A cap rate is short for capitalization rate. The term is usually used in real estate when people are talking about the rate of return they can expect to make or want to make on an income producing property. Huh?

Okay. Lets say an owner wants to sell his property for $1,000,000. He is also advertising that his property has a cap rate of 6%. Now here is where a majority of people check out. People see numbers, and their eyes roll up in the back of their head, their breath becomes shallow, and they break out in hives. No, really. But you know what? Its not hard. Really really.

There is a formula that Ive used for years when talking about commercial property. It is:

Rate x Paid = Made

Rate is the rate of return, the interest rate, the cap rate, that you are using with this particular property.

Paid is what someone would actually pay for the property. The value.

Made is the money the property generates after expenses, which is called the Net Operating Income, or NOI. Whenever somebody mentions NOI, remember, it means then money made after expenses, but before the payment of the loan.

So back to the example. If the owner says the property is worth $1,000,000 and has a cap rate of 6%, then we know that he is saying the money you can expect to make after expenses is:

Rate 6% x Paid $1,000,000 = Made $60,0000.

Now lets suppose an investor wants to make 7% on his money, so hes going to use a 7% cap rate when looking at properties. This means he doesnt care what the owner is asking. He cares about what the NOI is when determining the maximum amount he would be willing to pay. Hell then compare it to the asking price and see if the owner is asking what the buyer is willing to pay.

Example.

Our investor wants 7%. Our owner has a property listed for $2,500,000 with a reported NOI of $40,000.

The investor doesnt care yet what is being asked, he cares about the NOI.

Formula: Rate 7% x Paid = Made $40,000

According to our formula, hes going to take the7% and divide into the NOI.

.$40,000/.07 = $571,429. The most our investor would pay is $571,429.

Which means he would not be buying this property.

The cap rate is used by brokers and investors to determine what a property is worth and how much an investor would be willing to pay.

posted by affiliate-sites46843 @ 12:17 PM