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, property's value becomes inflated. For example if that same property existed in a market where cap rates were at 5%; $500,000 divided by 5% = $10,000,000. In this capacity the income capitalization approach very much drives commercial property valuation since it's historically held as an alternative asset class and to hedge against inflation by large funds and institutions.