Cap Rates: The Simple Math of Real Estate Investing

Cap Rate - this is probably the first and most fundamental concept to understand as a real estate investor. You may have heard someone say something like, “I bought the property for an 8% cap rate and sold it for a 5% cap rate” and found yourself nodding but on the inside you had no clue what this meant.

Don’t worry! Like most of real estate, it sounds complicated but it’s actually straightforward once you understand the jargon. (Side note, this is true for many things in life.)

Cap rates are the simple math that drive so much of real estate analysis. And fortunately you don’t need to be a “math” person to understand it. You learned all you need in Algebra I. It can literally be done on the back of a napkin.

Now that I have hopefully eased the concerns of all the math haters, let’s dig in.

Cap Rate is a commercial real estate term. It is short for “capitalization rate”. It is often used interchangeably with “Return on Costs”. Both refer to the investor’s annual return (example 5% per year) on their investment. It changes, and hopefully grows, over time.

Cap rates are also the key method through which real estate investments are valued.

Cap Rate = Net Operating Income Divided by Cost

Mathematically, it is the “net operating income” (NOI) divided by “cost”. Note that NOI changes over time; even cost can grow over time as you invest in renovations. NOI is:

NOI = Revenue - Operating Expenses.

It loosely reflects the cash flow from a property without debt. Note that operating expenses do not include interest you pay your lender or capital expenses (renovations). Don’t worry about this for now.

Cost is what you pay to purchase the real estate, also referred to as your purchase price. But…your costs can grow over time as you renovate the property and pay leasing commissions to put new tenants in place (or renew existing tenants).

Lower Cap Rate = Higher Cost

Let’s look at the math and see how price changes with cap rates using a consistent NOI.

• 10% Cap Rate = $10,000 NOI / $100,000 Price

• 9% Cap Rate = $10,000 NOI / $111,111 Price

• 8% Cap Rate = $10,000 NOI / $125,000 Price

• 7% Cap Rate = $10,000 NOI / $142,857 Price

• 6% Cap Rate = $10,000 NOI / $166,667 Price

• 5% Cap Rate = $10,000 NOI / $200,000 Price

Wow! The difference between the price buying at an 8% cap rate and a 5% cap rate is huge: $125,000 vs $200,000. That’s a 60% price increase for the same NOI.

Key takeaways: (1) lower cap rate = higher cost and (2) this is not linear; price goes up a lot with increasingly lower cap rates. This is great if you are selling and bad if you are buying.

If you can sell at a 5% cap rate instead of a 7% cap rate, you are selling at $200,000 instead of $142,857. This is a 40% increase.

NOI and Costs Can Change Over Time

Let’s go through an example to show the importance of how NOI and costs can change over time as you own a property.

In-Place NOI

You are buying a property 100% leased to one tenant with two years left on the lease. The NOI at time of purchase is $10,000. This is referred to as your “In-Place NOI”.

Market NOI

You believe you can increase the rent when the tenant’s lease expires in two years and increase the NOI to $15,000. This is referred to as your “Market NOI”.

Now let’s transition to your costs.

Purchase Price

You are paying the seller $165,000. This is the purchase price.

Total Acquisition Costs

But…you have to pay various additional costs to buy the property such as legal and inspection fees. Your total costs to buy the property are $170,000. This is your “Total Acquisition Costs”.

Total Costs at Stabilization

And…to hit the rent target you want when the lease expires in two years, you are going to have to renovate the property and pay a broker leasing commission. Let’s assume all of this can be done for $30,000.

Your costs are now $165,000 + $5,000 + $30,000 = $200,000.

Purchase price + closing costs + renovation/commission costs. This is referred to as your “Total Cost at Stabilization”.

Your Math Building Blocks

We’ve covered a lot. Let’s summarize and see what this tells us.

• $ 10,000 - In-Place NOI based on the existing lease.

• $ 15,000 - Market NOI based on what you think it could lease for in two years.

• $165,000 - Purchase Price that you pay the seller.

• $170,000 - Total Acquisition Costs including your closing costs.

• $200,000 - Total Cost at Stabilization including your renovation and commission costs.

Now we can do some cool and simple things to calculate the cap rates to tell us more about the investments.

Cap Rate Calculations

• Going-In Cap Rate (Seller’s View): $10,000 / $165,000 = 6.1%

• Going-In Cap Rate (Buyer’s Reality): $10,000 / $170,000 = 5.9%

• Stabilized Cap Rate (Buyer’s Goal): $15,000 / $200,000 = 7.5%

The $30,000+ Error

The one that gets the most muddled up in discussions is the last one. People often use the calculation of Market NOI divided by Total Acquisition Costs:

$15,000 / $170,000 = 8.8%.

They forget that they will need to spend an additional $30,000 to achieve that increased rent and NOI. Be careful.

Finding Meaning in the Math

So what does all this tell us?

In this example the buyer’s going in cap rate is 5.9% but will grow to 7.5% once the rent is increased in two years. This shows you how the going in cap rate may not tell the whole story of what the property could be worth, particularly at times when market rents have grown significantly.

From the outside, someone may question you buying in at a 5.9% cap. They might not know that you see a path to get to a 7.5% cap rate, which makes the investment much more attractive.

Key Takeaways

You will hear cap rates talked about regularly. Now you know how simple the math is. Don’t be shy about asking someone to clarify what they are referring to with their calculations.

NOI: in place or market?

Cost: purchase price or all in acquisition costs or total costs at stabilization?

Don’t be surprised if they don’t really know or have even made a math error. Be humble and supportive. We are all still learning.

Professor Bateman