Going-in cap rate and how to use it
As mentioned, there are several different variations of cap rate, and they have different applications.
The going-in cap rate is the version that is most useful when evaluating a potential investment opportunity and is calculated by dividing the property's expected first year net income by the purchase price.
For example, let's say that you just bought an apartment property for $3 million and that it produces $250,000 in NOI during your first year of ownership. Dividing $250,000 by $3 million shows a going-in cap rate of about 8.3%
Investors can also work backwards if they know the market-average cap rate for a certain property type, which can help them determine whether the seller is asking a fair price or if they should offer considerably less. Some quick algebra shows that if you divide a property's expected first year NOI by the market cap rate, you can determine a property's fair market value.
As a simplified example, let's say that you know that Class-A office properties in your real estate market are selling at an average cap rate of 6%. If a property you're looking at should produce $500,000 of NOI during the first year of your ownership, dividing by 6% (0.06) shows that $8.33 million would be a fair purchase price to pay. So, if the seller is asking $9 million, you know that you should be able to get the property for significantly less.
Other uses of cap rate
You can calculate the cap rate of a property at any point in time by using its NOI and its estimated market value, but since it's generally used to value a property, it's typically only used in two situations -- when buying or selling a commercial property.
The other common version is known as the terminal cap rate (or exit cap rate), which is the property's NOI in the last year before you sell it, divided by the sale price.
It can also be useful to compare your going-in cap rate with your terminal cap rate when you sell a property to help gauge the profitability of the investment. Specifically, if your terminal cap rate is lower than your going-in cap rate, it indicates that your property sold for more than you paid for it, relative to the income it generates. Conversely, a terminal cap rate that's higher than your going-in cap rate indicates the opposite.
The Millionacres bottom line
It's important to keep in mind that when it comes to real estate investing, no single metric ever tells the whole story about a property. So when you're shopping for an investment property, going-in cap rate should be used in conjunction with other metrics -- such as the cash-on-cash return as well as qualitative factors, like the property's condition -- in order to form a complete picture of how much you should pay for (or offer for) a particular real estate investment.