By Drew Mitchell, VP – Development (Portage, IN)

Cap rates defined & studied by sector

Wander the hallways of one of Holladay’s offices around the country, and you won’t go long without hearing the phrase “cap rate”.  Cap rate, short for “Capitalization Rate” is a calculation or ratio used to relate the value of rents to the value of a property.

Let’s start with a few simple examples to illustrate this concept:

Example 1: An industrial building is on the market for sale at a price of $100,000.  The property is occupied by a business, which pays $8,000 per year to the landlord.  The tenant separately pays for all other expenses such as real estate taxes and insurance (in its simplest form, where 100% of rents are passed through, this is called a “triple net”, or NNN, lease).

Therefore, the property’s Net Operating Income (NOI) is $8,000.  NOI = rents less expenses but before mortgage payments (the expenses in this scenario are 0 because of the NNN lease).

The Cap Rate is calculated by taking the NOI divided by Value.

NOI ÷ VALUE = CAP RATE        $8,000 ÷ $100,000 = X

X = .08, or 8%.

This property would be called an “8-cap”.  And the lower the cap rate, the higher the value.

But what if you don’t know the value?  What if you only know the rents and are trying to approximate the value to determine if you would want to sell a building?  How does one discover if a building is priced appropriately?

In this case, you might look to recent sales transactions and market trends and identify cap rates for comparable products.

Example 2: For this example, let’s again assume that our operating income is $8,000.  But this time, let’s assume the rents are from an apartment building, and we are trying to determine its value.

Studying the chart below, I can see that recent cap rates in the Apartment sector are approximately 6.25%.  We also know our operating income is $8,000.  Fill in the formula, and you get your value:

NOI ÷ VALUE = CAP RATE        $8,000 ÷ X = 6.25%

X = $128,000

The property should be valued at approximately $128,000, though the exact value will depend on a variety of factors.

So out of this simple example comes a simple question:  Why is $8,000 in annual rents for the industrial building worth only $100,000, while the $8,000 in annual rents for the apartment building is worth $128,000? (28% more!) 

Why is $1 here not the same as $1 there?

Want to know the answer? Read the exciting conclusion of this post: “Capitalization Rates 101.”