Cap Rate … What is it?

For every commercial real estate opportunity, someone is going to tell you the Cap Rate. We all know that the Cap Rate, when divided into Net Operating Income (NOI) gives you the purchase price. We also know that the Cap Rate roughly represents the return for one year on a commercial real estate investment. But does that mean it’s the right rate for you?

It’s useful to break down the Cap Rate between the mortgage component and the equity component. Here’s an example:

What We Know

The things we know (or should know) when we’re contemplating a real estate purchase include:

Net Operating Income (NOI) – \$1,000,000 annually. Remember that a property’s NOI does not include debt service – principal or interest payments. This isn’t the time for a lengthy discussion, but be sure to do your due diligence to prevent unpleasant surprises.

Mortgage rate – 5.0%

Mortgage term – 25 years

Loan to value ratio (LTV) – 75% of purchase price

Mortgage Component – Calculate the Mortgage Constant

The mortgage constant is the annual payment, or debt service, expressed as a fraction of the total mortgage. From the bank’s point of view, this is the Cap Rate on their investment in the loan.

In this example, the annual payment on a \$100,000 mortgage (any amount will give the same result) at 5.0% amortized over 25 years is \$7,015.08. This is the portion of NOI that goes to make debt payments.

Annual debt service of \$7,015.08 is 7.0158% of the \$100,000 mortgage in this example, so the mortgage constant is .0701508

Equity Component – Calculate the Equity Constant

How much do you want to make on your equity investment? Let’s say you’re looking for a 15% cash on cash return.

Your return is 15% of your equity investment, so the equity constant is .15.

Calculate the Cap Rate

Mortgage component of the Cap Rate:

Mortgage constant (.0701508) x LTV (75%) = 5.26%

Equity portion of the Cap Rate:

Equity constant (.15) x Equity contribution (25%) = 3.75%

Cap Rate:
Mortgage component (5.26%) + Equity component (3.75%) = 9.01%

Calculate the Purchase Price

Net Operating Income (\$1,000,000) ÷ Cap Rate (9.01%) = \$11,097,165

If you pay more than \$11,095,165 for the property, you won’t make your target return. This may limit you to certain types of property investments, so you may want to adjust your expectations. If you are willing to accept a 12% return on your equity investment in this example, your Cap Rate would drop to 8.26%, and you could pay \$12,104,617 for the property.

Capital Appreciation

Of course, 101 other questions arise when you are contemplating this sort of decision. Foremost among them is how you view capital appreciation. With a 75% mortgage, if the property value increases by 1% a year, you gain 4% on your invested funds. If you build appreciation and/or rent increases into your projections, you can pay a lot more for the same property and still make your target return. That’s how high quality properties can sell at a 4% or 5% cap rate.

Do you know who to call to discuss Cap Rates?