How Much Do You Know About Cap Rate?
Have you ever been asked about a property’s “cap rate” and you stood there gazing like a deer looking into the headlights of a car?
Then read on. This one’s for you.
Here’s a brief description of one of the most common investor rules-of-thumb on the planet. It’s not Accounting 101, but it might spare you the embarrassment of looking confused the next time you’re asked about it. Cap Rate
Cap rate is really a shortened version of the term “capitalization rate,” and intends to express the ratio between net operating income and sales price.
FORMULA: NOI/Sales Price = Cap Rate
EXAMPLE: $10,000/$100,000 = 10.0%
Okay, test your understanding. Does cap rate measure the ratio between net operating income and sales price? Right. But from the example, what is it that cap rate reveals in essence? Answer: That the net operating income is 10.0% of the sales price.
So when someone wants to know the property’s cap rate, what do they really want to know? Right again. What percent of the sales price is net operating income?
Good. Now let’s define net operating income so you can see why someone had to create a rate to measure it in the first place.
Net Operating Income
Let’s deal with the technical stuff first.
Net operating income is the annual income of an income-producing property after a property’s income is reduced by vacancy and credit loss and all operating expenses. Mathematically, it is a property’s gross operating income less the sum of all operating expenses.
FORMULA: Gross Operating Income – Operating Expenses = Net Operating Income.
Great, now let’s see the truth behind net operating income and why measuring it against sales price is significant to an investor.
Thus far, we’ve discussed income and expenses, and what we haven’t discussed holds the key. Namely, the mortgage payment.
You got it. All the fuss over net operating income is due to the fact that it represents the amount of money a property produces that pays the mortgage. In other words, after rents are collected and all operating expenses are paid, the amount of money left over to pay the mortgage is the net operating income.
See the logic? In as much as cap rate measures the percent of sales price that is net operating income, what it really answers for the investor about the property is this: What percent of the property’s sales price is available for the loan payment?
So there you have it. The bottom line. Cap rate expresses the percentage of sales price available to pay the loan. Is there any one ideal cap rate? No. Nor does cap rate alone provide a true picture of a property’s profitability. But it is a rule of thumb. And as a first-glance assessment of a property’s ability to pay its own way, it has become a popular way to do it.
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