Cap rate is a measure that compares the amount of capital invested in a deal to the net annual return on the investment. It is given in the form of a ratio, and generally used to evaluate real estate deals.
Q. So we know you’re at the Bisnow Real Estate Conference in Miami today, so this is a real estate term. What exactly is a cap rate, and how do you use it?
A. It’s a very common way to evaluate a real estate deal. Simply stated, the cap rate of an investment gives you a ratio that shows how the capital invested in a deal compares to the net annual return on that investment. Or, put another way, it shows you how many years it’ll take to earn your money back.
Q. So, can you give us an example?
A. Imagine a building costs you $10mm and generates rents of $4mm/year. Now lets say that the fixed and variable costs of the building run something like $3mm/year. Your net income is $1mm, so your cap rate is $1mm/$10mm, or 10%. It’ll take 10 years to recover your investment. With a cap rate of 5%, it’ll take you 20 years. The higher the cap rate, the faster you get your money back.
Q. And how do professionals actually use the number?
A. A couple of different ways. First, of course, it’s a great adjunct to a traditional appraisal, which looks mostly at “comparables”…. Which can be really hard to define. So it’s a big issue in price negotiations. And the second way for an investor is in comparing this deal to other real estate deals he could invest in, something that an appraisal, of course, won’t tell you. Good apples to apples metric.
In that regard, its sort of interesting to note that, like other financial metrics the #s will be risk adjusted. So buildings in an area with a lot of crime will generally have a higher cap than buildings in a super fancy neighborhood, to compensate the buyer for the risk he’s taking.
Q. OK, got it. So are there any big mistakes we should avoid in figuring cap rates?
A. The biggest one individuals make is not adjusting the computation for changes in the value of the property over time. If you have a low basis in a property, the cap rate might seem very good, better than you can get elsewhere. But you could, of course, actually sell the property and put the money elsewhere. To really see “how your investment is doing”, you should not go by initial investment, but what the opportunity cost is in having your dollars tied up in the project. To do that, adjust the denominator to today’s value.