Cap rate is an abbreviation for capitalization rate. To compute a cap rate, the first year Net Operating Income (NOI) is divided by the price, as expressed in the formula below:
Cap Rate = Net Operating Income / Purchase Price
The NOI is almost always a smaller number than the price. That is because buyers can usually expect real estate to generate cash flow for several years. This makes buyers willing purchase at a price that is higher than the amount returned in just one year. The ratio of NOI over price results in a percentage, known as a cap rate, that shows the share of the price the buyer will receive back by the end of the first year of operation. The cap rate equation does not take into account the impact of debt financing. Instead, it assumes that buyers pay all cash.
Cap rates are typically used as an initial gauge to estimate whether a price is reasonable given the NOI a property produces, after which other valuation methods can be used to come up with a better estimate of market value, as discussed further on the How to Find the Market Value of Investment Real Estate article.
Some of the common techniques used to value investment real estate include the cost approach, the sales comparison approach, gross income multipliers and, perhaps most frequently, the income capitalization approach.
This final approach involves converting the income-producing potential of a property into a value. One way they do that is by looking at the cap rates of comparable properties at the time of their sale and then dividing the NOI of the subject property by the average cap rate from those sales.
For example, if the average cap rate from several comparable sales is 8%, the appraiser would take the NOI of the subject property and divide by 8% to arrive at its value. This is known as using the Direct Capitalization Approach. This approach can work well when it is relatively easy to find data on sales of comparable properties.
However, when sales comps are unavailable, it becomes necessary to consider the present value of the property's future cash flows over a projected holding period. Valuing property this way is known as the Discounted Cash Flow (DCF) method. Those who use Microsoft Excel would use the Net Present Value (NPV) function to make the computation.
The accuracy of this valuation technique depends upon the level of care taken to develop the multi-year cash flow forecast. It is essential to use an appropriate discount rate, which should be determined by finding the total returns available from other investment opportunities available in the capital markets with a similar level of risk.
Another way to find discount rates is by finding cap rates at comparable properties and then adding the expected cash flow growth rate to arrive at the total expected return. The discount rate should also equal the cost of capital, which should be the weighted average cost of the investor's debt and equity.
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