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Commercial Mortgage 101: Capitalization Rate

Overview

When buyers and agents ask you what is the cap rate for a listing, they are referring to the capitalization rate, which is a common ratio used to evaluate the investment return for income-producing properties. Cap rates can vary greatly depending on property type, collateral quality, market area, and availability of financing. A property’s cap rate can also indicate a perceived immediate upside or downside to the investment, depending on whether it is in line with the prevailing cap rates for similar properties in its market area.

Definition

In technical terms, it is the rate at which you discount future income to determine present value. In practical terms, a cap rate is the relationship between a property’s value and its net operating income for the first year of operations. You divide the NOI by the property value to determine the cap rate. While it is an important ratio for investors, it is limited in its scope because it does not take into account such factors as cost of capital, tax savings, and future resale value. However, as a commonly accepted metric, it is a crucial one to know and understand.

  • Divide the NOI by the property value to determine the cap rate:
    Net Operating Income / Value = Cap Rate

    Divide the NOI by the cap rate to determine the property value:
    Net Operating Income / Cap Rate = Value

    Multiply the property value by the cap rate to estimate the NOI:
    Value X Cap Rate = Net Operating Income

  • For example, let’s say you were trying to determine the market value for a property so you can list the property. You already know the NOI, so after conducting a survey of the prevailing cap rates, you present your findings to your client during a listing presentation:

    NOI Cap Rate Listing Price
    $100,000 5.00% $2,000,000
    $100,000 5.50% $1,818,182
    $100,000 6.00% $1,666,667

    As you can see, higher cap rates can result in lower market values. That’s why it’s important to know the prevailing cap rates for a market area and property type: it will help you determine a realistic price for a property.