What is Cap Rate and How to Calculate it

October 13, 2008

What is cap rate, and how do you calculate it? Cap rate is a good way to evaluate a property and that property’s value. In a nutshell, the higher the cap rate, the better the investment that property may be.

Cap rate is used for a number of reasons. For our purposes, we are going to look at what a hard money lender looks at when evaluating a potential loan. First things first, how do we calculate a cap rate? With some basic information, it is not terribly difficult. First you need to know the net operating income for the property, or NOI. NOI is the income minus the expenses of a property, not including the debt service for the existing mortgage. So if your property brings in $100,000 per year, and expenses amount to $40,000 per year, your NOI would be $60,000. NOI should be expressed as an annual number for this calculation.

Next you need to look at the value of your property. Divide your NOI by the value of the property and you will have your cap rate. In the example above, a $1,000,000 property with an NOI of $60,000 would have a 6% cap rate. When evaluating a property, the higher the cap rate is, generally speaking, the better investment that property would be to purchase. A $1,000,000 property with a 6% cap rate would generate $60,000 per year in net operating income. That same property with a 10% cap rate would generate $100,000 per year in net operating income. Pretty basic.

Where it gets tricky is when you look at where your numbers come from. For a cap rate to be a beneficial number to look at, it is very important to know that your numbers are accurate. If you have inflated income numbers, or understated expesnses, your cap rate is not going to be accurate. Like anything else, if it is not accurate, you cannot rely on it.

In the lending world, we use the cap rate in a backwards fashion from how I have explained it above. When looking at a property and making a decision on whether or not to make a loan against it, valuation is paramount. Cap rate is a good, quick way to estimate this valuation. If we know the NOI for a property, and know the cap rate for comparable properties in the area, we can quickly calculate an estimated value.

Using the same example as above, if we have a property with $60,000 net operating income, and we know the average cap rate for comparable properties in the area is 8%, we can divide $60,000 by .08 (8%) to arrive at an estimated value of $750,000 for that property.

That is cap rate in a nutshell. If you have questions or would like to talk with me about obtaining a commercial loan here in California, please call me today. You can always reach me at 877 462 3422, ask for Chris!

Posted in Terms and Definitions