What are Cap Rates as They Pertain to Commercial Real Estate Finance?
The Cap Rate, otherwise known as the Capitalization Rate, is the expected return on investment on a commercial property. The Cap Rate is calculated by dividing the net operating income of a property by its market value. This is the key tool appraisers use to determine the value of a commercial property and is the key metric behind the income capitalization approach to valuation.
How Do You Calculate a Cap Rate?
For example, a property with a NOI: Net Operating Income of $500,000 and a market value of $5,000,000 would have a capitalization rate of 10 %. Working it backwards, if you know a commercial property’s net operating income and at what cap rates similar properties (commercial properties of similar vintage and asset class) are trading for in that sub-market, you can use that relationship between the NOI and the capitalization rate, to determine the property value.
In this particular example, $500,000 (NOI) divided by 10% (cap rate) = $5,000,000. In an environment with compressed or lower cap rates, s property's value becomes inflated. For example, if that same property existed in a market where cap rates were at 5%, then $500,000 divided by 5% = $10,000,000. In this capacity the income capitalization approach definitely drives commercial property valuation since it's historically held as an alternative asset class. It also hedges against inflation by large funds and institutions.