Cap Rates Explained

Are you thinking of selling or buying a income producing property and want to know what it’s worth is as an investment.

By Frank Jones

What's it Worth? Calculate Your Capitalization Rate

How do you know what a commercial income property is worth? How do you know that you can get your desired return on your investment? Is there a way to calculate the maximum you can pay for an investment and still achieve your investment goals? This article will answer these questions and more about valuing income property. Many real estate investors determine the value of an income property by using the capitalization rate, a.k.a the cap rate.


Say the property has an NOI "Net Operating Income" of $125,000, and the price is $1,500,000.

$125,000/ $1,500,000 = 8.33% cap rate “rounded”.

This does not tell you what your return will be if you use financing. Also it doesn’t take into account the different finance terms available to different investors? What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, to find the cash on cash return on our actual investment using leverage. Now calculate the debt service to finance the investment, subtract that from the NOI, and calculate the return. In order to correctly find the cap rate and get equal comparison, you must know the correct income and expenses for the property, and that the calculations of each were done in the same way. A wide range of cap rates for property types with different risk and management requirements, which may or may not apply to the property you are looking at, and certainly does not take into account your own return requirements compared to the Market Cap Rate . So what do you do when you've found a property that looks promising, and the Seller tells you the cap rate is 11.1% and you better act fast? How do you know if it is worth pursuing?

What's it worth to you?

The real question is not how much I (or another investor, or even an appraiser) value a property at. Nor is it the value from a cap rate estimated in the market. It's the value at which YOU can attain YOUR investment goals, that is reflective of YOUR borrowing power, and gives you an intelligent starting point for the analysis. I promise you if you learn how to do this, it will give you a leg up on 90% of the investors out there. Critical to this calculation is that the NOI is figured consistently with industry norms. The generally accepted definition of NOI is:
Gross Income - Operating Expenses = NOI

Please note that the operating expenses do not include debt service or the interest component of debt service. Obviously, the income and expenses must be verified, or all calculations that flow from them will be flawed. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can settle the income stream conclusively.

Your Realtors normal due diligence includes verifying with third party suppliers as many of the expenses as possible. But take care evaluating the operating expenses to uncover any anomalies that exist under the present ownership.

Owners often take a management fee that may or may not be market based; maintenance expenses may or may not include labor charges; items such as "office expense," "professional fees," or "auto expense" may or may not be property specific.

In short, before accepting the NOI presented, understand what is behind the numbers. This is known as "normalizing" the numbers. You can also tweak the numbers to reflect the way you will own and manage the property.

No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOI, and two widely divergent values, and both are right.

That's why appraisers use comparable sales, replacement value, and the income approach as part of a three-pronged method in estimating value. They make the appraisal representative of the market conditions and the typical requirements of investors and lenders active in the market.

The third method, the income approach, is usually given the most weight. That method is also known as the "band of investment" method of estimating the present value of future cash flows. It addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.

Deriving your cap rate

After you are reasonably certain that the NOI is accurate, Find the derivative capitalization rate. It requires two more pieces of information: You have to know the terms of financing available to you and the return you want on your investment.

We then use these terms for both debt and equity to indicate the value at one precise point in time--the instance of when the operating numbers are calculated--to derive the cap rate that reflects those terms. (The value in future years is another discussion.) Deriving a cap rate works like a weighted average, using the known required terms of debt and equity capital.

The bank's return: the loan constant

We need to know the terms of the financing available. From that we can develop the loan constant, also called a mortgage constant. The loan's constant, when multiplied by the loan amount, gives the payment needed to fully repay the debt over the specified amortization period.

IT IS NOT AN INTEREST RATE, but a derivative of a specific interest rate AND amortization period. When developing a derivative cap rate, one must use the constant since it encompasses amortization and rate, rather than just the rate.

Using just the interest rate would indicate an interest only payment and distort the overall capitalization process. The formula for developing a constant is:
Annual Debt Service/Loan Principal Amount = Loan Constant

You can use ANY principal amount for the calculation, then calculate the debt service and complete the formula. The constant will be the same for any loan amount. For example, say your bank says they will generally make an acquisition loan at a two points over prime, with twenty-year amortization, with a maximum loan amount of 75% of the lower of cost or value.

Say prime is at its current 4.5%. That means the loan will have a 6.5% interest rate. Using a payment calculator or loan chart, find the payment for those terms. On a loan for $10,000, the annual debt service required is $894.72. Divide that by $10,000 to find the constant.
894.72/10,000 = .08947

Using the terms given then, the loan constant for that loan would be .08947 rounded to five digits.
The answer will be the same if you use $100,000 or any other number as the principal amount. (One hint: do not use a principal number with less than five digits, because the rounding will affect the outcome.)

You might note here that the mortgage constant is basically the lender's cap rate on his piece of the investment. Both the mortgage constant and "cash-on-cash" rates for equity are "cap" rates in their basic forms. A cap rate is any rate that capitalizes a single year's income into value (as opposed to a yield rate).

Your return: cash-on-cash return

The next step is to provide for the return on the equity. Start with the return you want on your money: Say the cash-on-cash return you are seeking is 20%.
If an investor puts in $30,000 and requires a 20% pre-tax return, then his annual cash in the pocket after paying the mortgage (but before income taxes) would have to be $6,000. In this case, the equity constant is .20.

Put it all together: Weighted average

Each of these cap rates is then weighted based on the loan-to-value ratio of each of the debt and equity positions to build the "overall cap rate." The formula looks like this:
(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant)
= derived cap rate

To finish the example, using the mortgage terms given above, and the desired 20% cash on cash return, the following would be the overall cap rate with a 75% loan-to-value on the debt component:
(.75 x 0.08947) + (.25 x 0.20) = .1171
.0671 + .05 = .1171

To convert to a percentage, move the decimal two places, and therefore, under the stated conditions, the required cap rate for the property (income stream) is 11.71%. Using the normalized NOI figure, then the indicated value is calculated with this formula:
NOI/Cap Rate = Maximum Purchase Price to achieve your investment goal.

For the original deal above, the value would be calculated thusly to attain the desired return:
$125,000/11.71% = $1, 067,464

The asking price of $1,125,000 is very close to my target of $1,067,464. This is a deal that would definitely be worth taking a look at.

The other factors

Many factors can influence the value of an income property both positively and negatively. Some of the more important include maintenance; security of the income stream (strength of the tenants and length of the leases); comparable sales in the area; general economic and market conditions; and local market conditions; future area development and or restrictions.

All these factors and more speak to the relative risk and effort involved in the continuance of the income stream, and must be investigated during the due diligence by yourself and your Realtor.

Increase the required return and the cap rate changes, and so does the price. At this point you are writing your own paycheck.

In Closing

I hope you found this information useful and if you’re thinking of buying or selling an income producing property here in the Central Toronto area and would like a team of professionals representing your best interests, you’ll give me a call.
Feel free to ask me any questions you might have about buying or selling residential or commercial real estate.

Thanks for visiting my website.
Frank Jones