How is cap rate determined?
The cap rate formula is rather simple: Take the property's NOI and divide it by the current market value of the property.
If you're considering purchasing a property or recently acquired the property, you can consider its "value" to simply be the purchase price. If you're calculating cap rate in any other year, you can use a recent appraisal that estimates property value or your best estimate of the property's value. And if you sell a property, you can calculate your exit cap rate by using the selling price.
As an example, let's say you're considering two properties. One costs $2 million, and you expect it to generate $140,000 in first-year NOI. The other costs $3 million and will produce $180,000 in NOI. Dividing $140,000 by $2 million shows a cap rate of 7% for the first property, and dividing $180,000 by $3 million gives a cap rate of 6% for the second.
Different uses of cap rate
If you calculate cap rate based on the price you're paying for a property and its expected first-year NOI, that's called the going-in cap rate. This can be useful when assessing the profitability of your real estate investment and when trying to compare two or more properties you're considering, as we saw in the example in the previous section.
On the other hand, by calculating the exit cap rate (also known as terminal cap rate) using last year's NOI and the price at which you sold the property, you can assess whether your real estate investment was profitable. If your exit cap rate is higher than your going-in cap rate, that can be a sign of an exceptionally successful investment.
One of the most common uses of cap rate is to use the property's NOI and the market average cap rate to determine a property's fair market value. Commercial real estate firm CBRE publishes a semiannual Cap Rate Survey (here's a recent version) that can be used to find market average cap rates.
For example, if you own a hotel property that generates $200,000 in NOI and the market cap rate for the property type is 9%, a little algebra shows the property has a fair market value of about $2.22 million.
The Millionacres bottom line
As a final thought, remember that cap rate is only one way to value commercial real estate, and it's not a perfect one. For one thing, it doesn't take the property's condition into account, nor does it consider other value-adding variables like the amount of land the property sits on or overall local real estate market conditions. Even so, cap rate can be an excellent starting point when trying to determine the market value of a commercial property investment opportunity.