Cap Rate Basics
Understand capitalization rates and their role in commercial real estate
What is Cap Rate?
In the last lesson, you learned how to calculate Net Operating Income (NOI). Now let's discover what that NOI means for property value using the Capitalization Rate (Cap Rate), also known as the unlevered return.
The Basic Formula:
This gives you the annual return percentage if you paid cash
Real Estate Example:
Property Price: $1,000,000 • Annual NOI: $80,000 • Cap Rate: 8.0%
Just like earning $80,000 per year on a $1,000,000 investment
Why Cap Rates Matter
Comparing Properties
“Should I buy Property A with a 6% cap rate or Property B with an 8% cap rate?” Cap rates let you compare different properties on equal footing.
Understanding Risk
Higher cap rates usually mean higher risk. A 10% cap rate might offer more money but with more risk, while a 5% cap rate may offer a more stable return.
Calculating Value
If you know the NOI and cap rate, you can find property value. This helps you determine if a property is priced fairly.
The Simple Formula
The cap rate formula is actually three formulas in one. You can rearrange it to find different pieces of information depending on what you know:
NOI ÷ Price
“What return will I get?”
NOI ÷ Cap Rate
“What should I pay?”
Cap Rate × Price
“How much income do I need?”
Why “Unlevered” Return?
Cap rate is called the “unlevered return” because it excludes the effects of financing (leverage). It shows the return based purely on the property's performance, as if you paid 100% cash. This makes it perfect for comparing different properties regardless of how they're financed.
Continued Example
Let's continue with our Tuna's Tower Apartments from the NOI lesson. We calculated the NOI, now let's see what cap rate this property offers and what that means.
🏢 Tuna's Tower Apartments - Cap Rate Analysis
Property Details:
- Purchase Price: $3,200,000
- 20 units at $1,500/month each
- 5.0% vacancy rate
- Year 1 NOI: $231,460 (from NOI lesson)
Cap Rate Calculation:
What Does 7.2% Mean?
- • If you paid $3,200,000 cash, you'd earn 7.2% annually from NOI
- • That's like earning $231,460 per year on your $3,200,000 investment
How Investors Make Money: NOI Growth = Value Growth
Cap rates are market metrics determined by what similar properties sell for in your area. As rents increase over time or expenses decrease, NOI grows. If the market cap rate stays the same (7.2%), the property value increases. This is how investors build wealth - by increasing income and controlling expenses, not by arbitrarily deciding what cap rate their property deserves.
Interactive Calculator
Try the calculator with different NOI and property price combinations. Start with ourTuna's Tower Apartments example ($231,460 NOI, $3,200,000 price) and see how changes affect the cap rate.
Property Information
Key Insights
- • Cap rate connects a property's NOI to its price, showing how much income you earn relative to what you pay
- • It's an easy way for investors to understand how much money a property makes compared to its purchase price
- • Beware of sellers using pro forma (projected) rates instead of actual current NOI
- • Cap rates differ significantly across locations and property types - urban vs rural, office vs retail
- • Higher cap rates indicate higher returns but potentially higher risk or lower quality assets
Reading the Market
Cap rates vary by property type, location, and market conditions.
Understanding Pro Forma vs. Actual Numbers
Sellers sometimes advertise cap rates based on projected income rather than actual income. A property listed as “6% cap rate” might actually be 3% based on current, actual rents.
Tuna's Tower Apartments Analysis:
At 7.2%, Tuna's Tower Apartments falls in the “value-add or secondary market” range. This suggests it might be in a smaller city or need some improvements, but offers good income potential. Remember: this 7.2% cap rate comes from researching what similar 20-unit apartment buildings actually sold for in the same market, not from wishful thinking.
Key Takeaways
What You've Learned:
- • Cap Rate = NOI ÷ Property Price - This tells you the unlevered return (as if you paid cash)
- • Cap rates are “unlevered” returns - They exclude financing effects, showing pure property performance
- • Higher cap rates usually mean higher risk - A 10% property isn't always better than a 5% property
- • Cap rates help you compare properties - They put different properties on equal footing regardless of financing
- • Cap rates differ across locations and property types - Different markets and property types (office, retail, multifamily) trade at different cap rate ranges based on their risk profiles
- • You can rearrange the formula - Find cap rate, property value, or NOI depending on what you know
Test your understanding with these 3 questions. You must get all answers correct to complete the lesson.