The cap rate is an important concept in commercial real estate and it is widely used. There is often confusion about how to calculate the cap rate using various methods. The purpose of this article is to demonstrate several ways to calculate the cap rate.
How to Calculate the Cap Rate Ratio
Perhaps the simplest place to start is to calculate the actual cap rate ratio. The cap rate ratio is just net operating income (NOI) divided by value, so if we know what a property’s net operating income is and we also know what a property’s value is, then we can easily calculate the cap rate.
For example, suppose we know that a property has an NOI of $100,000 and a value of $1,000,000. Then we can calculate a cap rate by dividing $100,000 by $1,000,000:
This results in a cap rate of 10%.
How to Calculate the Cap Rate with Sales Comps
Since a property’s value is often what we don’t know, it is common to simply divide our known net operating income by a market based cap rate. This will tell us what a property’s value is.
Calculating a property’s net operating income is easy enough, but if we don’t know what the market based cap rate is, then how do we calculate it?
One approach is to find comparable properties that have recently sold. Then we can take those comparable sale prices and calculate a cap rate. For example, suppose we observe the following recent sales of similar properties:
Based on our knowledge of the local market we might decide to simply average all three of these cap rates to get a market based cap rate of 8.33%. Now we can use this market based cap rate to figure out a value for our property. If our property has an NOI of $100,000 then we can find its value like this:
This is the expected market value of our property using the direct capitalization method, based on recent comparable sales we observed in the local market.
How to Calculate the Cap Rate With The Band of Investment Method
Sometimes there aren’t any recent comparable sales to use in order to calculate a cap rate. One other approach commercial real estate appraisers use is called the band of investment method. This allows us to calculate a cap rate based on market based loan terms as well as investor’s required return. Appraiser’s usually find this information by surveying local lenders and investors and asking them what their current requirements are.
For example, suppose we survey local lenders and ask them what their typical loan terms are for a property similar to ours. We find out that we can get a loan at a 75% loan to value ratio, amortized over 20 years, at a rate of 6%.
We can now use this loan information to calculate a mortgage constant of 0.8597.
Likewise, suppose we survey local investors and find out that they would on average require an 11% cash on cash rate of return for investing in a property similar to the one we are evaluating.
Now we have all the information we need in order to estimate a cap rate using the band of investment method. To do this we simply take a weighted average of the return to the typical lender and the the return to the typical investor. In this case it is (75% * 0.8597) + (25% * 11%), which equals 0.6448 + .02750, or 6.72%. This is our market based cap rate rate using the band of investment method.
How to Calculate the Cap Rate Using the Discount Rate
Another way to calculate the cap rate is based on the relationship between the cap rate and the discount rate. When income and value grow at a constant rate, then the discount rate is equal to the cap rate plus the growth rate. This idea comes from the dividend discount model, also known as the Gordon Model, which is used to value a stock.
We can re-arrange this equation to solve for cap rate, which says that the cap rate is equal to the discount rate minus the growth rate:
So, if we know the required rate of return (discount rate) for a property, and we also know the expected growth rate for the property’s NOI, then we can calculate the cap rate. For example, suppose we know the discount rate is 12% and the NOI growth rate is expected to be 3%. This is how we can estimate the cap rate:
The cap rate is calculated as 12% minus 3%, or 9%.
In this article we discussed several ways to calculate the cap rate. First, we talked about how to calculate the simple capitalization rate ratio when you know both the NOI as well as the value of a property. Next we discussed how to estimate the cap rate when you don’t know the value of a property. This can be done by finding cap rates for recent sales of comparable properties. Sometimes there aren’t any comparable properties to extract a market based cap rate from. When this happens, commercial real estate appraisers often use the band of investment method to calculate a cap rate. This involved surveying lenders and investors to ultimately calculate a cap rate based on a weighted average of these lender and investor return expectations. Finally, we covered the relationship between the cap rate and the discount rate and walked through an example of how the cap rate can be calculated based on the discount rate and the expected growth rate of net operating income.