Understanding Capitilization Rates

Capitilization rates, or cap rates, are a way to get an understanding of a commercial property’s value. Put simply, the cap rate is the rate at which the property makes money. For instance, if a \$100 property made \$10 per year, the cap rate would be 10%.

Inverse relationship: Here’s a FREE bonus definition for you today! An inverse relationship is when two values move in opposite direction in relation to each other. A playground teeter totter is an example of an inverse relationship. When Jack and Jill teeter totter, when Jack goes up, Jill goes down. Inversly, when Jack goes down, Jill goes up. Nothing to this stuff, right?

Cap rates have an inverse relationship with the value of the property. As the cap rate goes up, the value of the property goes down. Our example property above had a cap rate of 10% because it made \$10 on a \$100 property. If we lower the cap rate to 6%* the value of the property goes up to \$166. If we were to raise the cap rate to 12% the value of the property would go down to \$83.

For Kansas City Commercial Real Estate, as well as the rest of the United States, we use Net Operating Income, or NOI for the income portion of the equation. Here comes your second free definition of the day! Here is the simple equation to calculate NOI:

Gross Income – Operating Expenses = Net Operating Expenses

When calculating NOI, do not include debt service or interest from the debt. Once you have the NOI, it is easy to calculate cap rates and property values:

Cap Rate = Net Operating Income / Property Value
10% = \$10 / \$100
6% = \$10 / \$166
12% = \$10 / \$83

Property Value = Net Operating Income / Cap Rate
\$100 = \$10 / 10%
\$166 = \$10 / 6%
\$83 = \$10 / 12%

Now you can use cap rates!

*For simplicity sake, this is roughly the going rate for US apartment properties for the trailing 12 months according to Real Property Analytics.

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