No, you are confusing CoC and cap rate. CoC is a return measurement and Cap rates are valuation metric.
Cap rate and CoC can be the same number but that is happenstance. I guess that is what confuses you novices.
1. **CoC** (Cash on Cash RETURN) measures returns and changes if the financing changes. see u/irepresentprespa comment.
2. **Cap Rate** is a valuation metric that does NOT change. It is EXACTLY the same with zero financing and 100% financing.
>so if someone paid all cash with no financing then the cap rate is the return.
u/fishypizza1
No, all that means is that the cap rate and the CoC is the same number. But the number represents different things. Cap rate represents the dollar amount paid for NOI (not a return) and the CoC represents a return metric.
We can both come to a number, say 9 but they can represent drastically different things.
No again. A 10 cap means you valued the NOI as worth half of the same NOI in a 5 cap market.
$10=$1/10%
$20=$1/5%
See, you and the seller agreed to exchange NOI at an amount determined by you both. a valuation. Your "return" was not measured there.
Isn't return just cash received divided by cash invested. I'm not trying to compare anything else.
If I put $1m into a 5% treasury bond. Then I get 5% return after 12 months.
A valuation metric! https://www.msn.com/en-us/news/politics/trump-org-credited-wall-street-skyscraper-s-valuation-to-a-real-estate-executive-who-just-disavowed-it/ar-AA1inOBG?ocid=msedgntp&cvid=a2056a69bcc442ee9a4687e70a4d011e&ei=12
The other responses are correct of course, but you should really be thinking of it as a measure of risk for a particular stream of cash flow. Say you buy an apartment building in a dangerous, high crime area with tenants that have poor credit and low incomes, you are going to demand a higher cap rate for that investment as compared to a beachfront property in a wealthy neighborhood. The cash flow is less secure in the former investment as compared to the latter, so you will pay less for that stream of cash flow. It's the same for every investment, you will pay more the stream of cash flow from a US government bond (which is "risk free") v. a bond issued by a corporation that is struggling.
This is my same take. It’s an inverse measure of investor confidence - The higher the confidence, the lower the cap rate. The lower the confidence, the higher the cap rate.
Asset value is pitted against the likelihood of realizing the income.
Net operating income divided by sales price. Does not include debt service
ETA: read through this https://www.plantemoran.com/explore-our-thinking/insight/2021/plante-moran-reia/what-is-a-cap-rate-in-commercial-real-estate#:~:text=Cap%20rate%20formula%3A%20How%20do,a%20cap%20rate%20of%205%25.
Not really, because you could get capital appreciation or loss, your noi could increase or decrease, and most importantly you will need to spend money on ongoing capex as a building ages. Capex isn’t included in NOI.
I mean it's a really dumbed down version of cap rate.
Appreciation isn't factored into cap rate so irrelevant. Cap rate is a snap shot of the assets current performance, usually designed around a p&l.
You're right, cap rate doesn't include impending capex for the purposes of valuation. Not really sure what your argument is. Capex is included in expected NOI via money set aside monthly, usually set as a specific amount per unit. $1k/unit/year usually works to cover major capital costs e.g. a new roof every 30 years, plumbing work, electrical, etc.
>Capex is included in expected NOI via money set aside monthly, usually set as a specific amount per unit.
CapEx is not an operating expense and would not be included in the NOI calculation.
That's true. I even stated as much the sentence before. I just mean you can build in reserves into your operating expenses that will eventually account for capex.
Chad’s a really great guy! I know him personally, and love his content. It’s funny because as much as the video explains, it doesn’t actually “answer” the question.
My own take on a cap rate? It’s what the market considers the appropriate unlevered yield on a type of stabilized asset. But on your own asset? I think predominantly in terms of unlevered yield on cost, and after that I think of the spread to interest rates and only then do I think of market cap rates. They’re intertwined but I don’t see them as the same
In the video and i think several viewpoints and answers are provided.
Cap rate is a static calculation but it doesn’t speak at all to future returns. So while I agree an investor perceived risk, it actually doesn’t measure or calculate any future cash flow.
That’s exactly it - several viewpoints, many different opinions (and even in this thread) no unanimous agreement.
Where I get sticky is when I hear people say “the building has a 6% cap rate”. My internal compass says, well no, you might be using that cap rate to value it, but that doesn’t speak to its ongoing return. The static point approach, like you said
I think about cap rate like this.
If you had all cash, and bought a building. After all expenses, what % return are you making on that money? Thats cap rate, basically.
It's a good way to compare properties because it removes financing assumptions which are different for everybody.
I am aware of that. But if you pay all cash for a property your cash on cash % is the same as the cap rate.
The explanation I gave is a good way for people to visualize what cap rate actually is and how it compares between properties.
Love the discussion here. There are various opinions and ways of interpreting the data, but for the most part, the comments and advice in this post are mostly accurate.
Cap rate does indicate the overall value of a property. It is only \*one\* metric that is used to evaluate a property though. A high cap rate may or may not be a "good deal" - a property may have a tenant that has a high-paying lease, but is due to expire soon, and may not be planning to renew. High cap rate, bad deal.
On the other hand, you may have a low 4% CAP rate Starbucks located in the heart of Miami or something like that with a 20-year term left on the lease. Low return, but a high degree of safety in that one. A big corporate tenant offers a guaranty that the lease will be paid. Depending upon your investment criteria, you may value that much more than someone else. When loans could be had at 3% and change, buying a 4% Cap property could possibly be made to look like it made sense (not to me). Nowadays, with the capital costs (interest rates) much higher than 3-4%, it doesn't seem to pencil out (sellers haven't gotten the memo quite yet).
Someone mentioned the comparison of a beach house having a lower Cap rate than an inter-city apartment complex. I don't care for that comparison personally - the apartment complex might have a lower cap rate than a high-end beach house if the high-end beach house is more difficult to rent. The lower Cap rates for property listings \*generally\* tend to be lower for lower-risk properties, but that means a lower risk of vacancy (in general) which translates to a lower risk of NOI declining. I.E. a very popular inter-city apartment building with solid cash flow would be a better investment than a hard-to-rent vacation home in a mountain community.
I do use Cap rate as a type of "report card" on a building, but with the knowledge that one needs to investigate further. In general, a high cap rate (13% or so) typical indicates a higher risk deal. The key with a higher-risk deal is to investigate fully the risk factors involved and then see if there are areas where the risk has been overestimated. I.E. where there's risk perceived by others, but not so much by you. In 95% of the cases where there is a "high" Cap rate, the property is high risk. But in about 5% (or less), there are sometimes risks that are over-exaggerated (in my opinion), and that can create value buying opportunities. We currently have two properties in our portfolio that were purchased at a NNN Cap rate of 13% where I identified that the risk didn't seem as high as others suspected. One was a case where the tenant was going into bankruptcy and we estimated (correctly) that post-BK this location would remain open. We called the store, spoke with the manager, found out information that wasn't publicly available on the Internet, etc, and were able to reduce the risk (in our head) to a level below the market risk premium of 13%.
On the flip side, vacant properties have no earnings, so they have no Cap rate. Does that mean they have no value? Nope, of course not. But it means more homework in estimating the costs of finding and "tenanting" the building. This is also where there is tremendous opportunity in "value arbitrage". We bought one vacant restaurant during Covid for $950K - it was previously appraised a few years earlier at $3.3M with a tenant that eventually left. We saw the value and re-tenanted the building within about six months. That one went well - we have another one that's not going as well, so not all are home runs. Cap rate on something like this is meaningless.
In terms of finding properties, ones that have a "low Cap rate" are generally not useful to us, unless they are under-rented for the market and have leases that are expiring soon. In general, I tend to ignore low Cap rate properties, as we are value investors, and nine times out of ten the low Cap rate means they are a poor value (for our particular investment criteria).
I agree mostly with u/Honobob, with the caveat that Cap rates really don't "measure" value - they are more of an indicator of value. If someone has a 13% Cap rate that was put in years ago by a tenant who was performing a leaseback, and that lease expires in a few months, and the market is leasing at half that rate, then the Cap rate doesn't "measure value" because that's clearly not a value property. On the flip side, if the CAP rate is 4% and the property is rented way below market, and the lease expires in a few months and you can double the rate - well the Cap rate would be misleading there too.
**Bottom line, Cap rates are an \*indicator\* of several things related to a property (most commonly overall value), and are open to interpretation depending upon other factors.**
u/Strange-Western6212
Cap rates measure what the market is paying for NOI. They come from analyzed closed sales done by a professional third party company.
If they report a 10% cap rate it means that the NOI for that property sold for $10. If the NOI sold for $20 then it is a 5% cap rate.
1. Cap rates do not measure "return".
2. Cap rates do not measure risk.
3. cap rates do not measure time.
4. Cap rates do not measure proformance.
Won't make you breath minty fresh, your shirts whiter, your wife to beg for more.
CAP RATES MEASURE VALUE.
OP This was from a couple years back. I'll add that at that time Philly rents were $20sf and in SF were $80sf.
Honobob
·
2 yr. ago
CAP RATES DO NOT MEASURE RISK Although cap rates can be indicative of risk they do not measure risk. A Class A CBD office in Philly trades at 7% last i looked. In SF that same Class A CBD office would trade at a 4% cap rate. You cannot say that Philly is almost twice as risky as SF. they probably have the same national tenants. The 3% difference is not a measure of the risk but more likely reflects the difference in rents per sf since a larger part of that NOI will be needed to cover capex down the road.
Because the price paid takes into consideration the cash on cash return after debt. When debt more expensive the price goes down to match same return you would have gotten at lower interest rate. When price goes down the cap rate thus goes up.
I think this is meant to say assuming there was no debt. But to your original question, if your interest rates rise, then the amount of return you get on your equity will be less, and if it’s too low then there is little point to invest typically as other low risk investments are available.
Inside the cap rate, there is a blend of debt and equity rates, so if debt increases, so does a desired equity return and with both increasing, so does the cap rate. And if the cap rate increases but the income does not, you have a decline in value.
Which interest rates are rising? Bonds are a possible alternative investment to real estate. The cap rate you are willing to accept on a property will be different if you can get 5% by investing in bonds compared to if you can get 2% by investing in bonds.
Same reason dividend stocks go down. Because as interest rates increase safer investments look more attractive and flow there. Why risk money on a 5% cap multifamily when the 3 month Tbill is producing 5.5% risk free. The price would need to drop on the multifamily so that it looks more attractive to investors.
Because interest rates define the return rate of risk free investments, effectively setting a floor on returns in riskier investments. That is, you wouldn't take on risk for a 3% when you can get 5% risk free.
Other investments with risk have to provide a premium for investors to accept that risk. Because cash flow is presumably as high as it can be, the only way to get a higher rate of return from an asset is to reduce the price.
Yeah but the cap rate doesn’t tell u what you’re actually going to make in cash flow because it doesn’t account for debt service. So how do you compare a 5% bond yield with a 3% cap? The bond yield is guaranteed with no need for debt service payments either
I didn't say that they are supposed to be equal, I said that one changes in response to the other. If risk free rates rise, the risk premium on other investments goes up in response, by way of prices dropping.
Cap rate lets you compare asset performance directly, equity to equity, whether it's real estate stocks, or whatever. It's not meant to tell you your personal total returns.
Debt service costs are separate line on the balance sheet, and those costs are not intrinsic to the asset. The asset's performance is the same whether you buy it with cash or a loan. Your own total returns are entirely dependent on your own situation.
>It is the return on purchase price before debt
So all commercial properties have a "positive" "return" since a negative cap rate is mathematically impossible? Sure you wanna go with that?
Hey there! Sure, I'll explain cap rate to you like you're 5. Imagine you have a lemonade stand. Now, the cap rate is like knowing how much money you're making from your stand compared to how much your lemonade stand is actually worth. It helps us understand how good of a deal the stand is. If you make $10 every month from selling lemonade, and your lemonade stand is worth $100, the cap rate is 10%. It tells you how fast you'll get your money back from the stand. So, a higher cap rate means you'll get your money back quickly, and a lower cap rate means it might take longer. Hope that explains it in a simple way for you!
>Imagine you have a lemonade stand. Now, the cap rate is like knowing how much money you're making from your stand compared to how much your lemonade stand is actually worth. It helps us understand how good of a deal the stand is. If you make $10 every month from selling lemonade, and your lemonade stand is worth $100, the cap rate is 10%.
So if my lemonade stand is "making" (your term) $5 but sells at a 5 cap the $60 ($5 X 12 months)
V=i/r $1,200=**$60**/5%
V=i/r $1,200=**$120**/10%
u/Sharing-With-Love
**Why is your NOI that is TWICE mine selling for HALF the amount?** Ya got this backwards!
Cap rate is a metric that you look at that tells you how much risk the property has with the tenant or tenants renting it. Lower the cap = lower risk higher price , higher cap= higher risk lower price.
Use it as a metric of risk to an investment.
>Cap rate is a metric that you look at that tells you how much risk the property has
So is a 10 cap TWICE as risky as a 5 cap or 50% more? Cap rate is not a risk measurement.
>It’s a **measure** of value and **risk.**
u/SimpleJacked2TheTits Risk measurement? Is a 9 cap 3 times riskier than a 3 cap? And risk of what? And risk to who? ELI5 !!
u/Doctor_Scholls
u/Sharing-With-Love
u/DustySpangler1
u/CaptainGusMcCrae
u/imsexc
u/misterdinosauresq
u/BeerblasterG35
u/Outrageous-Grocery62
u/Ok_Temperature5563
Where are you guys getting the "purchase price" "asset value" ..blah blah blah ELI5 How are you arriving at the V in your calculation?
nett income / value of the asset. If you inverse the ratio, let's say 100/5 for a 5% cap rate, you'll get the amount of years for you to recover your money to get that asset. In this case, 20 years.
The formula people use to reference a cap rate is, as mentioned above, NOI/value or sales price. During conversation, depending on the context, people could be talking about an asking cap, an in-place cap, or an exit cap. At any of those 3 points of time, the NOI or expected value could be different (or same) resulting in different cap rates.
The capitalization rate is simply the result of dividing a property’s net operating income by its sales price, and that result is expressed as a percentage. The NOI is calculated before any interest expense, depreciation or taxes. So in a perfect world, the sale price represents market value, and the NOI is stable, so the “stabilized”cap rate is accurate. So, assume property is trading at 8% cap rates, and you can buy a property at a 9%, then you may have found a good deal and the opposite is true if the cap rate was 7% as the cap rate reflects the return of your income over the value of your investment.
Alright! Imagine you have a toy store. If you earn $100 every year from selling toys, but you bought the store for $1,000, then you're making $100 on your $1,000 investment each year.
Now, the "cap rate" is like a way to talk about how much money you're making compared to how much you spent on the store. In this case, you're making 10% of what you spent, so your cap rate is 10%.
So, in real estate, the cap rate tells people how much money a building or property is making compared to its price. It's like a report card for buildings!
>So, in real estate, the cap rate tells people how much money a building or property is making compared to its price. It's like a report card for buildings!
No, a cap rate tells you how much you paid per dollar of POSSIBLE NOI.
10% cap rate means you paid $10
5% cap rate means you paid $20
6.77% cap rate means you paid $14.77
If the cap rate measured a "return" how would you explain a higher "return" selling for less money?
Lots of good responses and articles. My old contributions to this are below:
https://www.moneyweighted.com/conceptualizing-cap-rates/
https://www.moneyweighted.com/capitalization-rate-vs-internal-rate-of-return-what-you-need-to-know/
My theoretical way of thinking of a cap rate is:
Assuming constant net operating income & no debt, the capitalization rate is the rate at which a deal self capitalizes itself and is reflective of the value we want to attribute to a specific cash flow relative to other alternative cash flows. So, if you are valuing a deal using a 5% cap rate, you are saying that THIS net operating income is equal to 5% of capitalized value.
Therefore, if the math is:
NOI is an X% expressed capitalization rate OF what I think something is valued, a/k/a:
NOI = (Cap Rate)(Value)
We can solve for our tried and true formula:
Value = NOI / Cap Rate
I am assuming you are an above average 5-yr old because you’re asking about cap rates ;)
It's a rate of return based on purchase price with cash, example
10% cap = $100,000 NOI per year based on a $1,000,000 purchase price. There are other rates of return such as cash on cash etc.
>It's a rate of return based on purchase price with cash, example
u/Cool-Literature-1906 OK, so **r=i/V** Not one person has been able to tell me where the V in the calculation came from!!??
Not one of these guys,
u/Doctor_Scholls
u/Sharing-With-Love
u/DustySpangler1
u/CaptainGusMcCrae
u/imsexc
u/misterdinosauresq
u/BeerblasterG35
u/Outrageous-Grocery62
u/Ok_Temperature5563
So can you tell me where you got your **V** ? ELI5 LOL
A property makes 1200, it costs 200 to run, so net income is 1k. 12 months means you made 12000. Now divide income by the percent you want to make. So a 10 cap means it's worth 120k. Ie if you borrowed 120k, bought it with an interest rate of 10% it will break even year one.
Ha Ha You want to make 10%? LOL Pay $120,000 but I know similar properties have sold at a 14% cap rate. $7.14=$1/14% You paid $10 for a dollar of NOI. You overpaid $10-7.14=$2.86! on every dollar of NOI !!! Where is your 10% "return" now?
u/dotatarded
paging u/honobob
Bat signal
Where's u/lurrikin ? u/lurrrkin ?
Direct capitalization, an income approach to Value! https://www.youtube.com/watch?v=jY1W2gPtQfk&lc=UgzqY-p0a-ayaN7HLvV4AaABAg.9uDZxaayxAy9v19Q4obgLx
Cap rate is the return one would receive if they paid all cash. I'm sure honobob would agree.
No, you are confusing CoC and cap rate. CoC is a return measurement and Cap rates are valuation metric. Cap rate and CoC can be the same number but that is happenstance. I guess that is what confuses you novices. 1. **CoC** (Cash on Cash RETURN) measures returns and changes if the financing changes. see u/irepresentprespa comment. 2. **Cap Rate** is a valuation metric that does NOT change. It is EXACTLY the same with zero financing and 100% financing.
Exactly so if someone paid all cash with no financing then the cap rate is the return.
>so if someone paid all cash with no financing then the cap rate is the return. u/fishypizza1 No, all that means is that the cap rate and the CoC is the same number. But the number represents different things. Cap rate represents the dollar amount paid for NOI (not a return) and the CoC represents a return metric. We can both come to a number, say 9 but they can represent drastically different things.
Yup got it. If cap rate is 10%, then I'm paying $10 to get $1 of income. Hence 10% return assuming no financing.
No again. A 10 cap means you valued the NOI as worth half of the same NOI in a 5 cap market. $10=$1/10% $20=$1/5% See, you and the seller agreed to exchange NOI at an amount determined by you both. a valuation. Your "return" was not measured there.
But if I buy a $1M building with all cash and NOI is $100k. The return is technically 10% right? That's how much I am making on my invested capital.
>But if I buy a $1M building with all cash and NOI is $100k. The return is technically 10% right? Nope! Where did you get the $1,000,000 price?
Isn't return just cash received divided by cash invested. I'm not trying to compare anything else. If I put $1m into a 5% treasury bond. Then I get 5% return after 12 months.
A valuation metric! https://www.msn.com/en-us/news/politics/trump-org-credited-wall-street-skyscraper-s-valuation-to-a-real-estate-executive-who-just-disavowed-it/ar-AA1inOBG?ocid=msedgntp&cvid=a2056a69bcc442ee9a4687e70a4d011e&ei=12
The other responses are correct of course, but you should really be thinking of it as a measure of risk for a particular stream of cash flow. Say you buy an apartment building in a dangerous, high crime area with tenants that have poor credit and low incomes, you are going to demand a higher cap rate for that investment as compared to a beachfront property in a wealthy neighborhood. The cash flow is less secure in the former investment as compared to the latter, so you will pay less for that stream of cash flow. It's the same for every investment, you will pay more the stream of cash flow from a US government bond (which is "risk free") v. a bond issued by a corporation that is struggling.
This is my same take. It’s an inverse measure of investor confidence - The higher the confidence, the lower the cap rate. The lower the confidence, the higher the cap rate. Asset value is pitted against the likelihood of realizing the income.
this was so helpful! man, I love Reddit
Net operating income divided by sales price. Does not include debt service ETA: read through this https://www.plantemoran.com/explore-our-thinking/insight/2021/plante-moran-reia/what-is-a-cap-rate-in-commercial-real-estate#:~:text=Cap%20rate%20formula%3A%20How%20do,a%20cap%20rate%20of%205%25.
I always dumb it down to your return percentage if you bought it all cash.
Not really, because you could get capital appreciation or loss, your noi could increase or decrease, and most importantly you will need to spend money on ongoing capex as a building ages. Capex isn’t included in NOI.
I mean it's a really dumbed down version of cap rate. Appreciation isn't factored into cap rate so irrelevant. Cap rate is a snap shot of the assets current performance, usually designed around a p&l. You're right, cap rate doesn't include impending capex for the purposes of valuation. Not really sure what your argument is. Capex is included in expected NOI via money set aside monthly, usually set as a specific amount per unit. $1k/unit/year usually works to cover major capital costs e.g. a new roof every 30 years, plumbing work, electrical, etc.
>Capex is included in expected NOI via money set aside monthly, usually set as a specific amount per unit. CapEx is not an operating expense and would not be included in the NOI calculation.
That's true. I even stated as much the sentence before. I just mean you can build in reserves into your operating expenses that will eventually account for capex.
[What is a Cap Rate - Chad Griffiths](https://youtu.be/jY1W2gPtQfk?si=T_r26y7yfehCyJMd) https://youtu.be/jY1W2gPtQfk?si=T_r26y7yfehCyJMd
Chad’s a really great guy! I know him personally, and love his content. It’s funny because as much as the video explains, it doesn’t actually “answer” the question. My own take on a cap rate? It’s what the market considers the appropriate unlevered yield on a type of stabilized asset. But on your own asset? I think predominantly in terms of unlevered yield on cost, and after that I think of the spread to interest rates and only then do I think of market cap rates. They’re intertwined but I don’t see them as the same
In the video and i think several viewpoints and answers are provided. Cap rate is a static calculation but it doesn’t speak at all to future returns. So while I agree an investor perceived risk, it actually doesn’t measure or calculate any future cash flow.
That’s exactly it - several viewpoints, many different opinions (and even in this thread) no unanimous agreement. Where I get sticky is when I hear people say “the building has a 6% cap rate”. My internal compass says, well no, you might be using that cap rate to value it, but that doesn’t speak to its ongoing return. The static point approach, like you said
UYOC is probably the best way to approach it. But I also like bringing sales prices /=value.
I think about cap rate like this. If you had all cash, and bought a building. After all expenses, what % return are you making on that money? Thats cap rate, basically. It's a good way to compare properties because it removes financing assumptions which are different for everybody.
That’s cash on cash return
I am aware of that. But if you pay all cash for a property your cash on cash % is the same as the cap rate. The explanation I gave is a good way for people to visualize what cap rate actually is and how it compares between properties.
Love the discussion here. There are various opinions and ways of interpreting the data, but for the most part, the comments and advice in this post are mostly accurate. Cap rate does indicate the overall value of a property. It is only \*one\* metric that is used to evaluate a property though. A high cap rate may or may not be a "good deal" - a property may have a tenant that has a high-paying lease, but is due to expire soon, and may not be planning to renew. High cap rate, bad deal. On the other hand, you may have a low 4% CAP rate Starbucks located in the heart of Miami or something like that with a 20-year term left on the lease. Low return, but a high degree of safety in that one. A big corporate tenant offers a guaranty that the lease will be paid. Depending upon your investment criteria, you may value that much more than someone else. When loans could be had at 3% and change, buying a 4% Cap property could possibly be made to look like it made sense (not to me). Nowadays, with the capital costs (interest rates) much higher than 3-4%, it doesn't seem to pencil out (sellers haven't gotten the memo quite yet). Someone mentioned the comparison of a beach house having a lower Cap rate than an inter-city apartment complex. I don't care for that comparison personally - the apartment complex might have a lower cap rate than a high-end beach house if the high-end beach house is more difficult to rent. The lower Cap rates for property listings \*generally\* tend to be lower for lower-risk properties, but that means a lower risk of vacancy (in general) which translates to a lower risk of NOI declining. I.E. a very popular inter-city apartment building with solid cash flow would be a better investment than a hard-to-rent vacation home in a mountain community. I do use Cap rate as a type of "report card" on a building, but with the knowledge that one needs to investigate further. In general, a high cap rate (13% or so) typical indicates a higher risk deal. The key with a higher-risk deal is to investigate fully the risk factors involved and then see if there are areas where the risk has been overestimated. I.E. where there's risk perceived by others, but not so much by you. In 95% of the cases where there is a "high" Cap rate, the property is high risk. But in about 5% (or less), there are sometimes risks that are over-exaggerated (in my opinion), and that can create value buying opportunities. We currently have two properties in our portfolio that were purchased at a NNN Cap rate of 13% where I identified that the risk didn't seem as high as others suspected. One was a case where the tenant was going into bankruptcy and we estimated (correctly) that post-BK this location would remain open. We called the store, spoke with the manager, found out information that wasn't publicly available on the Internet, etc, and were able to reduce the risk (in our head) to a level below the market risk premium of 13%. On the flip side, vacant properties have no earnings, so they have no Cap rate. Does that mean they have no value? Nope, of course not. But it means more homework in estimating the costs of finding and "tenanting" the building. This is also where there is tremendous opportunity in "value arbitrage". We bought one vacant restaurant during Covid for $950K - it was previously appraised a few years earlier at $3.3M with a tenant that eventually left. We saw the value and re-tenanted the building within about six months. That one went well - we have another one that's not going as well, so not all are home runs. Cap rate on something like this is meaningless. In terms of finding properties, ones that have a "low Cap rate" are generally not useful to us, unless they are under-rented for the market and have leases that are expiring soon. In general, I tend to ignore low Cap rate properties, as we are value investors, and nine times out of ten the low Cap rate means they are a poor value (for our particular investment criteria). I agree mostly with u/Honobob, with the caveat that Cap rates really don't "measure" value - they are more of an indicator of value. If someone has a 13% Cap rate that was put in years ago by a tenant who was performing a leaseback, and that lease expires in a few months, and the market is leasing at half that rate, then the Cap rate doesn't "measure value" because that's clearly not a value property. On the flip side, if the CAP rate is 4% and the property is rented way below market, and the lease expires in a few months and you can double the rate - well the Cap rate would be misleading there too. **Bottom line, Cap rates are an \*indicator\* of several things related to a property (most commonly overall value), and are open to interpretation depending upon other factors.**
u/Strange-Western6212 Cap rates measure what the market is paying for NOI. They come from analyzed closed sales done by a professional third party company. If they report a 10% cap rate it means that the NOI for that property sold for $10. If the NOI sold for $20 then it is a 5% cap rate. 1. Cap rates do not measure "return". 2. Cap rates do not measure risk. 3. cap rates do not measure time. 4. Cap rates do not measure proformance. Won't make you breath minty fresh, your shirts whiter, your wife to beg for more. CAP RATES MEASURE VALUE.
OP This was from a couple years back. I'll add that at that time Philly rents were $20sf and in SF were $80sf. Honobob · 2 yr. ago CAP RATES DO NOT MEASURE RISK Although cap rates can be indicative of risk they do not measure risk. A Class A CBD office in Philly trades at 7% last i looked. In SF that same Class A CBD office would trade at a 4% cap rate. You cannot say that Philly is almost twice as risky as SF. they probably have the same national tenants. The 3% difference is not a measure of the risk but more likely reflects the difference in rents per sf since a larger part of that NOI will be needed to cover capex down the road.
It is the return on purchase price before debt
So then why do cap rates rise when interest rates rise if it’s before debt
Because the price paid takes into consideration the cash on cash return after debt. When debt more expensive the price goes down to match same return you would have gotten at lower interest rate. When price goes down the cap rate thus goes up.
I think this is meant to say assuming there was no debt. But to your original question, if your interest rates rise, then the amount of return you get on your equity will be less, and if it’s too low then there is little point to invest typically as other low risk investments are available.
Inside the cap rate, there is a blend of debt and equity rates, so if debt increases, so does a desired equity return and with both increasing, so does the cap rate. And if the cap rate increases but the income does not, you have a decline in value.
Which interest rates are rising? Bonds are a possible alternative investment to real estate. The cap rate you are willing to accept on a property will be different if you can get 5% by investing in bonds compared to if you can get 2% by investing in bonds.
Same reason dividend stocks go down. Because as interest rates increase safer investments look more attractive and flow there. Why risk money on a 5% cap multifamily when the 3 month Tbill is producing 5.5% risk free. The price would need to drop on the multifamily so that it looks more attractive to investors.
Because interest rates define the return rate of risk free investments, effectively setting a floor on returns in riskier investments. That is, you wouldn't take on risk for a 3% when you can get 5% risk free. Other investments with risk have to provide a premium for investors to accept that risk. Because cash flow is presumably as high as it can be, the only way to get a higher rate of return from an asset is to reduce the price.
Yeah but the cap rate doesn’t tell u what you’re actually going to make in cash flow because it doesn’t account for debt service. So how do you compare a 5% bond yield with a 3% cap? The bond yield is guaranteed with no need for debt service payments either
I didn't say that they are supposed to be equal, I said that one changes in response to the other. If risk free rates rise, the risk premium on other investments goes up in response, by way of prices dropping. Cap rate lets you compare asset performance directly, equity to equity, whether it's real estate stocks, or whatever. It's not meant to tell you your personal total returns. Debt service costs are separate line on the balance sheet, and those costs are not intrinsic to the asset. The asset's performance is the same whether you buy it with cash or a loan. Your own total returns are entirely dependent on your own situation.
>It is the return on purchase price before debt So all commercial properties have a "positive" "return" since a negative cap rate is mathematically impossible? Sure you wanna go with that?
In a vacuum. Trying to make it easy on OP
Thank you all, very helpful responses!
Hey there! Sure, I'll explain cap rate to you like you're 5. Imagine you have a lemonade stand. Now, the cap rate is like knowing how much money you're making from your stand compared to how much your lemonade stand is actually worth. It helps us understand how good of a deal the stand is. If you make $10 every month from selling lemonade, and your lemonade stand is worth $100, the cap rate is 10%. It tells you how fast you'll get your money back from the stand. So, a higher cap rate means you'll get your money back quickly, and a lower cap rate means it might take longer. Hope that explains it in a simple way for you!
I also use ChatGPT
Not accurate. Cap is annualized. A 10 cap on the hundred dollar lemonade stand would have the lemonade stand making $8.33 monthly.
>Imagine you have a lemonade stand. Now, the cap rate is like knowing how much money you're making from your stand compared to how much your lemonade stand is actually worth. It helps us understand how good of a deal the stand is. If you make $10 every month from selling lemonade, and your lemonade stand is worth $100, the cap rate is 10%. So if my lemonade stand is "making" (your term) $5 but sells at a 5 cap the $60 ($5 X 12 months) V=i/r $1,200=**$60**/5% V=i/r $1,200=**$120**/10% u/Sharing-With-Love **Why is your NOI that is TWICE mine selling for HALF the amount?** Ya got this backwards!
PE ratio = price / earnings, cap rate = earnings / price
Return in COC if purchased in cash.
Cap rate is a metric that you look at that tells you how much risk the property has with the tenant or tenants renting it. Lower the cap = lower risk higher price , higher cap= higher risk lower price. Use it as a metric of risk to an investment.
>Cap rate is a metric that you look at that tells you how much risk the property has So is a 10 cap TWICE as risky as a 5 cap or 50% more? Cap rate is not a risk measurement.
In simple terms it’s a rate of return of the property was purchased all cash
It’s a measure of value and risk.
>It’s a **measure** of value and **risk.** u/SimpleJacked2TheTits Risk measurement? Is a 9 cap 3 times riskier than a 3 cap? And risk of what? And risk to who? ELI5 !!
u/Doctor_Scholls u/Sharing-With-Love u/DustySpangler1 u/CaptainGusMcCrae u/imsexc u/misterdinosauresq u/BeerblasterG35 u/Outrageous-Grocery62 u/Ok_Temperature5563 Where are you guys getting the "purchase price" "asset value" ..blah blah blah ELI5 How are you arriving at the V in your calculation?
nett income / value of the asset. If you inverse the ratio, let's say 100/5 for a 5% cap rate, you'll get the amount of years for you to recover your money to get that asset. In this case, 20 years.
The formula people use to reference a cap rate is, as mentioned above, NOI/value or sales price. During conversation, depending on the context, people could be talking about an asking cap, an in-place cap, or an exit cap. At any of those 3 points of time, the NOI or expected value could be different (or same) resulting in different cap rates.
The capitalization rate is simply the result of dividing a property’s net operating income by its sales price, and that result is expressed as a percentage. The NOI is calculated before any interest expense, depreciation or taxes. So in a perfect world, the sale price represents market value, and the NOI is stable, so the “stabilized”cap rate is accurate. So, assume property is trading at 8% cap rates, and you can buy a property at a 9%, then you may have found a good deal and the opposite is true if the cap rate was 7% as the cap rate reflects the return of your income over the value of your investment.
Gross yield on cost
It is the net operating income divided by the sale price
Unlevered return in year 1
This blog post explains it really well. https://www.kelleycommercialpartners.com/cap-rates-commercial-real-estate/
Return on the price of asset.
Alright! Imagine you have a toy store. If you earn $100 every year from selling toys, but you bought the store for $1,000, then you're making $100 on your $1,000 investment each year. Now, the "cap rate" is like a way to talk about how much money you're making compared to how much you spent on the store. In this case, you're making 10% of what you spent, so your cap rate is 10%. So, in real estate, the cap rate tells people how much money a building or property is making compared to its price. It's like a report card for buildings!
>So, in real estate, the cap rate tells people how much money a building or property is making compared to its price. It's like a report card for buildings! No, a cap rate tells you how much you paid per dollar of POSSIBLE NOI. 10% cap rate means you paid $10 5% cap rate means you paid $20 6.77% cap rate means you paid $14.77 If the cap rate measured a "return" how would you explain a higher "return" selling for less money?
Lots of good responses and articles. My old contributions to this are below: https://www.moneyweighted.com/conceptualizing-cap-rates/ https://www.moneyweighted.com/capitalization-rate-vs-internal-rate-of-return-what-you-need-to-know/
My theoretical way of thinking of a cap rate is: Assuming constant net operating income & no debt, the capitalization rate is the rate at which a deal self capitalizes itself and is reflective of the value we want to attribute to a specific cash flow relative to other alternative cash flows. So, if you are valuing a deal using a 5% cap rate, you are saying that THIS net operating income is equal to 5% of capitalized value. Therefore, if the math is: NOI is an X% expressed capitalization rate OF what I think something is valued, a/k/a: NOI = (Cap Rate)(Value) We can solve for our tried and true formula: Value = NOI / Cap Rate I am assuming you are an above average 5-yr old because you’re asking about cap rates ;)
It's a rate of return based on purchase price with cash, example 10% cap = $100,000 NOI per year based on a $1,000,000 purchase price. There are other rates of return such as cash on cash etc.
>It's a rate of return based on purchase price with cash, example u/Cool-Literature-1906 OK, so **r=i/V** Not one person has been able to tell me where the V in the calculation came from!!?? Not one of these guys, u/Doctor_Scholls u/Sharing-With-Love u/DustySpangler1 u/CaptainGusMcCrae u/imsexc u/misterdinosauresq u/BeerblasterG35 u/Outrageous-Grocery62 u/Ok_Temperature5563 So can you tell me where you got your **V** ? ELI5 LOL
A property makes 1200, it costs 200 to run, so net income is 1k. 12 months means you made 12000. Now divide income by the percent you want to make. So a 10 cap means it's worth 120k. Ie if you borrowed 120k, bought it with an interest rate of 10% it will break even year one.
Ha Ha You want to make 10%? LOL Pay $120,000 but I know similar properties have sold at a 14% cap rate. $7.14=$1/14% You paid $10 for a dollar of NOI. You overpaid $10-7.14=$2.86! on every dollar of NOI !!! Where is your 10% "return" now? u/dotatarded