Cap rate meaning in plain terms
"Capitalizing" income means converting a stream of yearly income into a single value, and the cap rate is the rate used to do it.[2] Read one way, it is the yield on the price; read the other way, it says how many dollars buyers pay for each dollar of yearly net income.
| Cap rate | Price per $1 of NOI | Value |
|---|---|---|
| 4% | $25.00 | $1,250,000 |
| 5% | $20.00 | $1,000,000 |
| 6% | $16.67 | $833,333 |
| 8% | $12.50 | $625,000 |
| 10% | $10.00 | $500,000 |
The market cap rate is the reciprocal of this "NOI multiplier", which is why Texas A&M's Real Estate Center stresses that it expresses a relationship between income and value rather than a full rate of return.[1] The same research calls the cap rate on a property's total cost the "free and clear" rate of return, because no loan is involved.[1]
What goes into a cap rate
The numerator is net operating income: rent and other property income, minus vacancy and credit loss, minus the costs of running the property.[3] Mortgage payments, depreciation and the owner's income tax are left out, so the cap rate describes the property, not the owner's financing or tax position. The denominator is the purchase price for a buyer, or a current market value for an owner.
| Counts in NOI | Left out of NOI |
|---|---|
| Rent, parking, laundry and fee income | Mortgage principal and interest |
| Vacancy and bad debt (as a deduction) | Depreciation and amortization |
| Taxes, insurance, repairs, management, utilities | Income tax and loan fees |
What is a cap rate in commercial real estate?
In commercial real estate (apartment buildings, offices, shops, warehouses) the cap rate is the standard shorthand for pricing. Appraisers and analysts value a property with stable income by dividing its stabilized NOI by a market cap rate taken from comparable sales; when income is expected to change a lot, they use a discounted cash flow instead.[2] Agency apartment lenders size loans from the same NOI, testing it against the payment with a debt service coverage ratio of at least 1.25.[5]
For houses and small rentals the idea is identical, though owners in the UK and Australia more often speak of net rental yield, which is the same measure under another name.[4]
Going-in, market and exit cap rates
- Going-in cap rate: the first year's NOI divided by the price you pay.
- Market cap rate: NOI divided by sale price on recent sales of similar properties, used to estimate value.[2]
- Exit (terminal) cap rate: the rate used to estimate the sale price at the end of a projection, applied to the following year's NOI.[2] See the DCF calculator.
What moves a cap rate
A cap rate changes whenever either side of the fraction changes. At a fixed price, raising NOI by cutting costs or raising rents raises the cap rate. At a fixed NOI, a higher price lowers it. That is why sellers emphasize projected NOI and buyers recheck it line by line on an NOI calculator.
| Change | Effect on the cap rate |
|---|---|
| NOI up, price unchanged | Higher |
| Price up, NOI unchanged | Lower |
| Buyers expect faster income growth | Market cap rates tend to be lower |
| Buyers see more risk or more repairs ahead | Market cap rates tend to be higher |
Whether a particular cap rate is attractive depends on comparable sales, your cost of borrowing and how reliable the NOI is; the guide what is a good cap rate covers those tests.
Cap rate compared with other returns
A cap rate ignores financing, growth and the eventual sale. If you borrow, your cash-on-cash return can be well above or below it. Over a whole holding period, the internal rate of return on the investment property calculator captures what a cap rate leaves out. To compute a cap rate for your own property, use the cap rate calculator; for every step written out, see the cap rate formula page.
One-line definitionCap rate = NOI ÷ value. $36,000 of NOI on a $600,000 property is 6.00%.
Frequently asked questions
What does a 6% cap rate mean?
The property's net operating income is 6% of its price: $6 of yearly NOI for every $100 of value, or about $16.67 paid for each $1 of NOI.
What does cap rate mean in simple terms?
Cap rate means the share of a property's price that it earns back each year in net operating income, before any loan or income tax. A 5% cap rate means $5 of yearly NOI for every $100 of price.
Why is it called a cap rate?
Because it capitalizes income: it converts a year's net operating income into a value by dividing the income by the rate.
Is cap rate the same as ROI?
No. A cap rate covers one year of income on the full price with no loan. ROI usually measures the return on your own cash, including financing and the sale.
Does a cap rate include appreciation?
No. It only uses one year of net operating income. Expected growth shows up indirectly, because buyers accept lower cap rates where they expect income to rise.
Sources
- Etter, W. E. Expected Rate of Return: More than Interest (Publication 1145)
- Etter, W. E. Direct Capitalization Versus Discounted Cash Flow Analysis (Publication 1051)
- 203.01 Underwritten Net Cash Flow (Multifamily Selling and Servicing Guide, Part II, Ch. 2)
- Anari, A. Profitability of Texas Homes
- Conventional Properties Term Sheet (DUS)