CAP RATE BASICS

What You Need To Know About Cap Rates - Part 1

In a hurry:

 

Apply it today:

  • Cap Rate = NOI ÷ Price (or value)

  • Lower the cap rate, higher the price (and vice versa)

  • Don't forget about risk; higher the cap rate, higher the risk

 

By the end of this episode you’ll learn:

  • What is a Cap Rate?

  • How is it calculated?

  • How is it applied?

  • The ever-important inverse relationship

Have a few minutes:

The cap rate is arguably the most popular term in commercial real estate. Learn how this ratio calculated, how it’s applied and some of the key reasons this metric is the most popular term real estate investing.

 

The cap rate is a measure of investment performance. It measures the relationship between net operating income and price (or value).

 

You’ll often hear investors say “I want to buy this property at a <pick a number> % cap rate.”, implying how much income the investor wants to earn relative to the price (or value) of the property.

 

Developers, lenders, appraisers and almost every other member of the industry use the cap rate to make decisions on a day-to-day basis.

Cap rates are applied in two cases: 

  1. Before investing: prior to making the investment, to ensure you meet your return requirements

  2. When you are preparing to sell: If you evaluate another owner's investment using cap rate when you buy, it stands to reason that when its your turn to sell, investors will use cap rates to make their offer on your property

That's why you'll often hear investors refer to two kinds of cap rates:

  1. The going-in cap rate: the cap rate one can expect at the end of the first 12 months of owning the property

  2. The going-out cap rate: the cap rate used to estimate the price you will sell the property for at some point in the future

From the appraisal perspective, the going-out cap rate is typically higher than the going-in cap rate. There is some evidence to support that rule of thumb. While there isn't a standard practice, we have seen the going-out cap rate set at 50 to 100 basis points higher than the going-in cap rate (0.5% to 1.0% higher).

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