Terminology Brush Up: What is a Cap Rate?

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The cap rate; also known as capitalization, is a term that appears often when discussing real estate asset values and purchases. There are two key variables in the cap rate: net operating income (NOI) and current value of a property. In essence, cap rate is the rate in which net operating income recapitalizes the current value on an annual basis. By knowing the cap rate it allows investors to analyze real estate investment opportunities and understand the risk and reward involved in property investments.

Formula:

Cap Rate = NOI / Current Market Value

For example, let’s say that an investment group buys a housing complex in New York with an annual NOI of $1.5 million for $30 million. The cap rate in this situation is 5 percent.

1.5 million / 30 million = .05 or 5 %

At this rate, the asset will be able to pay itself off in 20 years.

What is Net Operating Income (NOI)?

Net operating income is all the revenue from the property minus all the necessary operating expenses. Besides rent and other revenue generating services, there are operating expenses required to run and maintain buildings such as insurance, property management fees, taxes, utilities, repairs, and so on. Remember that NOI is a before-tax figure; it also excludes principal and interest payments on loans, depreciation and amortization, and capital expenditures. NOI is not only used in the cap rate, but also in the debt coverage ratio (DCR) which shows investors whether a property’s income is able to cover its operating expenses and debt payments.

Furthermore on Cap Rates

There are different kinds of cap rates such as the trailing and the forward-looking cap rate. The trailing cap rate is what some investors use as a 12-month trailing income. The forward-looking cap rate looks at predictions of higher income in the next 12 months. The trailing cap rate can be very misleading at times in which the seller may actually anticipate different income and expenses compared to historical data. Therefore, it is crucial to look at every facet of the income statement and study them, in order to be certain if the facility is operating on a secure basis before investing in that property.

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