A Capitalization Rate (Cap Rate) is used for the valuation of an asset.
In this case, we will discuss commercial real estate. This valuation method is commonly misused as the return that an investor would yield during the holding period. One key to bare in mind is that the cap rate method assumes that there is no mortgage on the property. Unleveraged = no mortgage and Leveraged = mortgage. Cap rate always assumes that you pay cash. The cap rate is used as a “snapshot” of the Net Operating Income (NOI) that an investor would receive during a one year period.
The calculation is versatile, thus why it is the most common among commercial real estate investors.
As long as you know two of the variables, you can always solve for the third. The variables are:
- NOI (I)
- Value (V)
- Cap Rate (R)
For example, you have a Walgreens for sale at a 5% cap rate, and the cost is $2,300,500. To solve for the NOI, (assuming that the NOI has been properly calculated) you would multiply the value and the cap rate: V x R = I. $2,300,500 x .05 = $115,025 NOI. Now you know the NOI for that period of time. This is important because there are factors such as lease terms that can make a difference during the holding period of the asset.
Using the same numbers, let’s find the cap rate by using the NOI and the Value. To find the cap rate, you divide the NOI by the value I / V = R. $115,025 / $2,300,500 = .05 Cap Rate.
By now, I’m sure that you see the pattern. If not, let’s do one more calculation to figure out our value. I / R = V. $115,025 / .05 = $2,300,500.
Notice that the lower the cap rate, the higher the value and the higher the cap rate, the lower the value. This has to do with the risk involved with a particular asset. For example, a NNN lease with a credit rated corporate company will typically yield less risk than a franchise holder of the same business. Thus, the cap rate will be lower for the corporate lease; therefore, requiring a higher value.
Now that you’ve had your daily math lesson, feel free to contact me with any questions or post below!