Capitalization Rate: What Is It and Why Is It Important?

March 30, 2014

If you are just starting out in commercial real estate and want to function in this world, you need to become fluent in and have an understanding of capitalization rate, also known as cap rate. This is because commercial realtors, commercial appraisers, and commercial lenders all use cap rate to determine the accurate current value of a commercial property. 

Here is the easiest way to comprehend cap rate: Cap rate is simply the rate of return on the value of the property prior to financing. If you are interested in purchasing an apartment building in Dallas, Texas, for $1,000,000, and are paying cash for it, you will want to know what percentage of interest your money is earning annually on this investment. If the property has a net operating income (gross rents minus expenses) of $90,000 annually, then you are making a 9% return annually on your investment. This property is being sold at a 9 Cap. 

Annual Net Income/Purchase Price or Value x 100 = Cap Rate

$90,000/$1,000,000 = 0.09 x 100 = 9 Cap

Now let’s say that you are also interested in purchasing an apartment complex in San Francisco, and the realtor's marketing flyer states that the property is being sold for $1,000,000 at a 5.5 Cap. This means that your million-dollar investment will be earning $55,000 annually after expenses and before financing costs. At Apartment Loan Store, many of our clients are from California and are buying properties further east in locations like Dallas, where capitalization rates are higher. Yes, the higher the cap rate, the higher the net income will be on your investment. But some of our clients prefer properties in very solid expensive locations like the Berkley Marina or Santa Monica, California, where commercial properties are often sold at a 3 Cap.

As commercial lenders we look first at the capitalization rate to determine if the value of the property seems accurate based on market income and expenses for like properties. Commercial realtors price commercial properties based on what the market cap rates are in that sub-market. The last thing they want is for the property to appraise for less than the purchase price. A full commercial appraisal has three valuations or approaches: the sales comparable approach, the cost approach, and the income approach. The final valuation will be an average between the sales comparable approach and the income approach. The income approach is based on capitalization rate. It will compare the subject property and 3 to 5 other similar properties that have sold. The final value in the income approach will be an average of  the cap rates that the comparable properties sold at.

By Terry Painter, President