There was a time during the Industrial Revolution when a select group of astute individuals began realizing the opportunity of Commercial Real Estate. Â Running with the educated crowd was a man named Sir Walter Capital, who believed that a smart investment was a winning investment. In an effort to standardize his risk and comparable rewards, he conceived the ratio of income earned against investment cost, aptly named â€œCap Rateâ€.
Cap Rate is the standard performance ratio in Commercial Real Estate, and can simply be referred to as your return on investment (ROI).
Okayâ€¦ So if you clicked our Google link on Sir Walter Capital, a name we were sure would exist quite commonly throughout English history, and rather briefly admired an historic view of the Sir Walter Raleigh Hotel in North Carolina, you might now be wondering where the Wikipedia page on Walter actually went, or for those shrewd students of ours, just whether Walter mightnâ€™t exist.Â Instead, focus on the fact that youâ€™ve learned a very basic principle in Commercial Real Estate, invest smart by means of relativity (i.e. performance ratios), and for the time being weâ€™ll let Sir Walterâ€™s origins remain a mystery.
In case it emerges in everyday conversation, mainstream financial gurus interpret â€œCapâ€ as shorthand for Capitalization.
Again, it is best to consider a Cap Rate your return on investment. Although at its core a very simple concept, little has more importance in the Commercial Real Estate financial world.
So letâ€™s try a very basic application:
If you invested $1,000,000 to purchase a property that earned $70,000 per year, your Cap Rate (or ROI) is 7%.
Congrats, you just learned the first and most important lesson in Commercial Real Estateâ€¦ simple arithmetic!
Now letâ€™s rearrange the formula to achieve some other goals.
Suppose all we know is the Net Operating Income (NOI), or the return of the investment.Â Could we back into a purchase price?Â Sure we could.Â Divide the NOI by the desired return (or Cap Rate).
Starting to get the idea?
So we want NOI. Â Simply apply a Cap Rate to a given purchase price (again $1,000.000).
Now that you have an iron-fisted grasp on Cap Rates, letâ€™s move on to some Cap Rate 201!
So youâ€™re asking yourself, whatâ€™s the point of a Cap Rate, it seems pretty common sensical?
A Cap Rate is a very helpful tool in making investment decisions when comparing one property to another (Relativity: Einstein didnâ€™t mention it for nothing, hence â€˜common sensicalâ€™ above, the common sense relative form of common sense â€“ look it up).
An example: Given the opportunity to purchase Property A with an income of $75,000 or Property B with an income of $70,000, which property would you choose?
If you chose Property A, remind me never to let you advise me on any financial decisions.
Itâ€™s basic business sense: while Property A returns a higher dollar amount year to year, the increased income does not explain/permit the increased upfront cost! In terms of Property B, the lower purchase price outweighs the loss of income year to year, increasing the relative value of Property B to Property A (captured in the higher Cap Rate of 7%!).
You guys are getting really good at this!
As a side note, to all the wise-guys, this example assumes all else equal, otherwise known as: yeah, there are plenty of what-ifs out there (location, vintage, neighbors, regulations, etc.), but I donâ€™t want to hear them, a ratio only captures the relative performance of specific quantitative inputs and all other factors must be taken into account separately. Imbeciles!
You made it to the end of this perfect explanation of Cap Rate Calculation. Â As a reward for your hard work and dedication, we have included a FREE Cap Rate Calculator. Â Youâ€™re welcome.
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