Cap rate
Also called Capitalization rate, Capitalisation rate.
A cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
How it works
A cap rate is a price, quoted as a yield. Saying a property trades at a 5.4 cap and saying it trades at 18.5 times NOI are the same statement. Lower cap rates mean higher prices, and the relationship is a reciprocal, so the same 25 basis point move is worth far more at a 4 percent cap than at an 8 percent one.
What a cap rate embeds is a view about growth and risk together. Buyers accept a low going-in yield when they expect income to grow, when the asset and market are perceived as safe, and when capital is plentiful. They demand a high one for the opposite reasons. This is why a cap rate cannot be compared across markets or asset classes without adjustment: a 7 percent cap on a single-tenant building with four years of term left and a 7 percent cap on a stabilised apartment property are describing different risks that happen to share a number.
The most important discipline is denominator hygiene. NOI can be trailing, normalised or projected; price can be gross or net of closing costs; reserves may or may not be deducted. A quoted cap rate that does not say which definitions it used is a rumour. When comparing a deal to sale comparables, rebuild the comparables' NOI on your own conventions before drawing any conclusion.
Formula
Cap rate = net operating income / value- Rearranged: value = NOI / cap rate, and NOI = value x cap rate
- Going-in cap rate uses year-one NOI and the purchase price
- Exit or terminal cap rate uses the year after the sale year's NOI and the sale price
Worked example
Year-one NOI of $3,020,000.
| Purchase price | $55,900,000 |
|---|---|
| Going-in cap rate | 5.40% |
| Value at a 5.15% cap | $58,640,777 |
| Value at a 5.65% cap | $53,451,327 |
| Value swing across 50 basis points | $5,189,450 |
Fifty basis points is $5.2 million on this property, or about 27 percent of the $19.6 million of equity. Cap rate assumptions deserve more scrutiny than almost anything else in a model, and far more than they usually get.
Conventions worth knowing
- Cap rate is a first-year unlevered yield, not a return. It says nothing about growth, leverage, capital spending or hold period.
- It is least meaningful where income is not stabilised: a lease-up, a heavy renovation, or a development. On those, yield on cost is the more honest measure.
The common mistake
Comparing cap rates computed on different NOIs
A broker quoting a 5.0 cap on a pro forma NOI and a buyer computing a 5.9 cap on a normalised trailing NOI are looking at the same building and the same price. Neither is lying. Before any cap rate comparison, agree which NOI is in the numerator, whether reserves are deducted, and whether the price includes closing costs. Most disputes about where a deal is priced dissolve once those three questions are answered.
Related terms
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Going-in versus exit cap rateThe going-in cap rate is year-one NOI divided by the purchase price. The exit or terminal cap rate is the rate applied to the forward NOI at the end of the hold to estimate the sale price. The spread between them is one of the largest and least evidenced assumptions in any underwriting.
- Yield on costYield on cost is stabilised net operating income divided by total project cost, including land, hard costs, soft costs, financing costs and carry. It is the development and value-add equivalent of a cap rate, and the spread between it and the market cap rate is where the profit comes from.
- Cash-on-cash returnCash-on-cash return is a year's cash flow after debt service divided by the total equity invested. It measures the current income yield on the money actually at risk, ignoring appreciation and any eventual sale.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
- Debt yieldDebt yield is net operating income divided by the loan amount, expressed as a percentage. It measures the return a lender would earn on its loan if it took the property back and operated it, and unlike DSCR it is unaffected by interest rate, amortisation schedule or loan term.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.