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Understanding cap rates and the direct capitalization approach

Cap rate is the short form for capitalization rate. In real estate investing you will quickly learn that cap rate is one of the most commonly referenced metrics for investment consideration. It is a simple way to assess the financial performance of an investment, but as you’ll see in this article it does have limitations.

A cap rate is calculated and defined as:

For example, if a building produces $10,000 in net operating income and sells for $100,000, the cap rate can be calculated as 0.1. Cap rates are expressed as a percentage, so we would read this as 10 per cent.

The simplicity of this calculation allows it to be quickly rearranged to solve for an unknown figure. In the example above, we know NOI and value, but if we only had NOI and cap rate we can just as easily determine value. The usefulness of this is apparent as you will not always have all three pieces of information.

Because a cap rate can be calculated so quickly and easily, it has become a figure that investors and other real estate professionals use to compare one investment to another. Two investments may be under consideration, where both have wildly different list prices and NOIs, but if the same cap rate is applied to each you can more easily compare them.

Professional appraisers and real estate investors use a variety of different valuation approaches to determine value. The direct capitalization approach is just one of these and it relies on the same formula we introduced earlier. In financial terminology, the direct capitalization method values a building as a “perpetuity”. Effectively, the math underlying this calculation presumes that the investment will continue producing income indefinitely.

The cap rate serves as the “discount” that investors apply to this stream of income for the various risks that it comes with. There is no such thing as a risk-free investment, so investors place a discount on any income stream to account for potential problems and losses that may come with it. The cap rate simply tells us the ratio of income to price that investors are willing to accept for a future stream of income. A higher cap rate implies that a greater risk is perceived with the stream of income and therefore a lower value a buyer is willing to recognize.

What NOI are you using? This is the question that an investor should always be asking when looking at cap rates. There is no universally accepted NOI. This creates a problem for investors when they are trying to determine the market cap rate for a given investment. They may have heard that the property next door to the one under consideration sold “at a seven-per-cent cap” – when that might just be on “broker” numbers that overstated the NOI. If NOI is higher or lower, this will have a direct impact on the true cap rate at which the asset traded. It’s therefore important to work with your team to critically evaluate market comparables and carefully consider what cap rates you think are valid.

Should you use the direct capitalization method?

Cap rates and the direct capitalization approach to valuation is a useful tool to have in your toolbox as an investor. It allows for quick deal analysis and if done systemically with a critical lens can be a powerful technique. However, there are many supportive or alternative valuation methods besides just this one. Knowing when you need to do more than this one calculation is an important skillset when developing your deal analysis capability.