You may have heard someone ask, “What’s the cap rate?” or tell you that they “bought it at an 8 cap” (or more likely a 5 or 6 cap here in the DMV). But what is a cap rate and what does it mean?
Cap rate stands for capitalization rate and is what investors are willing to pay for a dollar of net operating income (NOI). It is used to determine the value of a property by dividing the NOI for the first year of ownership by the cap rate:
Value = NOI / cap rate
Example: An investor is considering purchasing a property with a forecasted year-1 net operating income of $100,000. If the market cap rate for similar properties is 6.5% then the investment value of the property would be $1,538,461.54.
The primary benefit to using cap rates to determine property values is its simplicity. It provides a gauge for what investors are willing to pay in a particular market for a particular asset class/property type.
Despite their common use in real estate investment conversations, the use of cap rates to determine property values have a number of shortcomings (4 Things That Cap Rates Aren’t Telling You). Cap rate is not synonymous with internal rate of return/yield, which is a more comprehensive measure of an investment’s performance.