Cap rate is short for capitalization rate. The cap rate is a common valuation metric for real estate assets. Investors familiar with stocks may be familiar with the price to earnings (or PE) ratio, which in essence is very similar to a cap rate. However, for cap rate, the definition is inverted such that it is "earnings" divided by price. In real estate, earnings are defined by the net operating income (or NOI). NOI is essentially the profit of an asset, revenues minus property expenses. Typically, expenses not directly related to the property (e.g. debt service or mortgage expenses) are not included in NOI calculation. The price is the market value of the asset, which is usually based on transaction price, though may be estimated by comparisons to other sales. Put simply, cap rate is equal to NOI divided by price (typically using trailing 12 months of NOI). The cap rate may also be used to help estimate the value of an asset if the cap rate is estimated using market comparables (comps).
Let's go through a basic example. Let's say a property has NOI of $1,000,000 and is being sold at $20,000,000. The cap rate is $1,000,000 divided by $20,000,000, which equals 0.05 or 5%. By convention, cap rates are reported as a percentage.
Conversely, if the market cap rate for a particular location and asset class is known to be 5% and an asset being reviewed has NOI of $1,000,000, then one could estimate the property value as $20,000,000 ($1,000,000 divided by 0.05).
As mentioned before, debt service or mortgage payments should not be included when calculating a cap rate. This is important for a number of reasons. Firstly, different assets may have different interest rates or loan terms, so by using cap rates without debt service, you are getting a more equitable comparison between assets to make things apples-to-apples. So essentially, the cap rate is if someone were to buy an asset without any leverage at all. This also can be helpful to understand the profitability of the asset itself without leverage. Leverage can increase returns, but also increases risk so it's helpful to understand the profit of the asset first and then assess the profit with leverage included.
Cap rates can sometimes go up over time or go down over time. Like other assets, asset valuation will depend on multiple macroeconomic variables in addition to earnings/profits. When cap rates go up or are projected to go up, the common vernacular is expansion of cap rates. On the other hand, when cap rates go down or are projected to go down, the common vernacular is compression of cap rates. Compression of cap rates is equivalent to prices going up while expansion of cap rates is equivalent to prices going down.
When assessing a prospective investment opportunity, the cap rate is frequently used to estimate the sales price upon exit. Understanding what numbers are used for this calculation helps to understand how realistic or conservative an investment projections are. If you are buying an asset at a 6% cap rate and hope to sell it at a 4% cap rate in 5 years, your likelihood of success is generally low (all else being equal) as it means that the market would have to appreciate over 30% for the same level of profits.
Cap rates are commonly used because they are easy to use and have become an industry standard. However, some critics will point out limitations to cap rates. Many investors may try to buy assets at high cap rates to get a bargain price. When making investment decisions, it is not only important to understand the cap rate, but the context around it including future earnings potential. In some cases, an asset may have a significant drop in earnings in the near future (e.g. a key tenant vacating) so using a cap rate based on trailing 12 months of earnings will neglect the upcoming drop in earnings. Conversely, in some cases assets may have a significant rise in earnings in the near future (e.g. rents below market price or a large vacancy that can be leased up). In these cases, sometimes it can be helpful to use projected earnings to calculate cap rate or use a different metric of valuation (e.g. price per door or price per square foot). In a similar vein, cap rates are often correlated to perception of risk. If an asset is considered risky (for instance a major tenant is on brink of bankruptcy), then the market will demand a discount for the risk and price will be lower and cap rate will be higher. Conversely, if an asset is considered safe (for instance, a good location with tenants that has a very strong balance sheet), then the cap rate will typically be lower as the market will be willing to pay a premium for the lower risk.
In short, the cap rate is a commonly used valuation metric, simply defined as earnings or NOI divided by price. Given its common use, it should be understood by any serious real estate investor. However, like all tools, cap rates need to be considered alongside other data points when assessing real estate investments.
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