Cap rate
A capitalisation rate is a property's net operating income divided by its value.
$24,000 of NOI on a $300,000 property is an 8 percent cap rate.
It works in both directions, which is most of its usefulness. Given a price it tells you the yield; given a market cap rate and an NOI it tells you what a property is worth.
What it deliberately ignores#
Financing. Cap rate uses NOI, which is calculated before debt service. Two buyers paying the same price — one in cash, one with 80 percent leverage — face the same cap rate.
That is a feature. It means cap rate describes the property, so properties can be compared without the comparison being polluted by whoever happens to be buying them.
It also means cap rate says nothing about your actual return. For that you need cash-on-cash, which does account for the debt.
Where the number goes wrong#
Almost always in the NOI, not the rate.
Vacancy assumed too low. No maintenance reserve. Management valued at zero because the owner does it. Property taxes taken at the current figure rather than what they become after a sale triggers reassessment.
Every one of those inflates NOI, and at an 8 percent cap each inflated dollar overstates value by twelve and a half. Overstate NOI by $2,000 and you have overstated the property by $25,000.
Sellers present pro forma NOI. Buyers should rebuild it from actual collections and actual expenses.
Comparing cap rates is harder than it looks#
A 9 percent cap in one market and a 6 percent cap in another are not a good deal and a bad one.
Higher cap rates compensate for something — weaker demand, older stock, more management intensity, less liquid exit, higher vacancy risk. The rate is the market pricing that risk, not a discount waiting to be picked up.
Cap rates are comparable within a market and property class. Across them they mostly describe different assets.
Where it fails entirely#
Single-family rentals in owner-occupier markets. In much of the Twin Cities metro, small houses are priced by what families will pay to live in them, not by what the rent supports. Cap rates there look poor because the property is worth more as a house than as an investment.
Vacant or non-stabilised property. There is no NOI to divide.
Anything with a short remaining lease on the income that makes up the NOI.
You can work the arithmetic through on our cap rate calculator, which also shows how the implied value moves as NOI and the rate change — the sensitivity is usually more informative than any single result.