When researching commercial real estate investments, one of the pieces of information you will frequently see listed is the property’s capitalization or “cap” rate. So, what is a cap rate?

A Cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. The cap rate simply represents the yield of a property over a one-year time horizon assuming the property is acquired with all cash``. It is basically a snapshot of that particular point in time to help you decide when it is right for you to buy and/or sell the property.

The cap rate is calculated by taking the Net Operating Income (NOI), which is the income received by the property, minus operating expenses, and dividing it by the purchase price. For example, if a property generates $100,000 of NOI in the first year of ownership and it sold for $2 million, the initial cap rate is 5%. ($100,000 divided by $2,000,000).

There are a several ways to calculate the cap rate depending upon where in the lifetime of the investment you are doing your calculations. One way is to use the previous year’s NOI divided by the current sales price; this is known as a trailing cap rate. Another way to do so, is to use the going in cap rate which is based upon the next year’s NOI. This is the most typically used evaluation, especially with new construction, or with leases that include scheduled rental increases. Cap rates are also influenced by the expected future NOI (rental increases), credit rating of the tenant, term of the leases (in years), and the liquidity available in that investment market.

For stabilized properties with predictable income streams, the cap rate metric can serve as a helpful valuation tool and can be useful for benchmarking opportunities against one another. For example, a tenant with a 10-year lease in one market will have a similar cap rate to the same tenant in a similar market. The investor in this example is less concerned about the actual land, than the creditworthiness of Rally’s and their ability to uphold the terms of the lease for the entire 10-year term.

An investment such as this is sometimes compared to being more like a bond, as the owner is buying a stable income stream. Because of that, the cap rates are generally lower (in the 6.0% – 7.0% range) and are based on the underlying credit quality of the tenant.

The cap rate is simply one of many factors investors should use to evaluate a real estate investment. It’s important to know what the cap rate represents and its limitations in order to understand how to use it when valuing real estate. The best valuation methods use a combination of cap rates, cash-on-cash return on investment and return on cost. Using cap rates in isolation can lead to poor outcomes.