The capitalization (cap) rate

The capitalization (cap) rate 

is a handy tool used to determine a property’s:

- yield, as a rate of return based on the asking price sought by the seller; and

- pricing, based on yields sought by buyers as a rate of return.

But how does the cap rate work, and how do agents use it when assisting income property clients? 


WHAT DOES THE CAP RATE MEASURE?

When an income property is presented for sale, the cap rate is presented as the yield from rental operations, in relation to the seller’s asking price.

Here, yield needs to be distinguished from profit. Both are stated as percentage figures and represent a return on invested capital, typically the price paid for a property.

A yield is the annual measure of net income generated by the operation of a rental property (residential or nonresidential). Also, it can be said that the yield a rental property produces is the property’s annual net operating income (NOI).

Profit, on the other hand, is the measure of gain realized on the sale of property over the period of ownership. Taxwise, profit is classified as a capital gain. It is calculated on a sale as the difference between the sales price and the price paid to acquire and improve the property, minus carrying and transaction costs.


Further, profit is a one-time event, taken on the sale of a capital asset. Conversely, yield is the continuing receipt of net operating income (passive or portfolio) during each year of ownership of a rental property.


SELLERS and BUYERS USE CAP RATES differently

As indicated above, the cap rate has two fundamental applications in income property sales:

FOR THE SELLER, it is the annual percentage yield the property’s NOI represents of their asking price; and it is a percentage of the asking price represented by the annual yield, or NOI;

FOR THE BUYER, it is the annual percentage yield sought by the buyer and applied to the property’s NOI to set the purchase price.

A buyer analyzes a property’s worth using a cap rate pre-established by the buyer based on the long-term outlook for the particular property. The cap rate the buyer establishes is applied to the property’s NOI to calculate the property’s present value. Thus, the buyer sets the maximum price to be paid to acquire the property based on the NOI, which needs to be confirmed by a due diligence investigation of rents and expenses.

AS YOU SEE, THE BUYER and SELLER HOLD DIVERGENT VIEWS ON THE CAP RATE.

HOW DOES THE BUYER DISCERN THEIR CAP RATE?

Just what is the value of a property, and further, what is the maximum price a buyer will pay to own it? This is the puzzle every buyer is confronted with when exposed to an income property. To resolve the puzzle, the buyer first needs data on the property’s:

- GROSS OPERATING INCOME (GOI), equal to the annual rent amounts presently received from the property’s tenants and the scheduled rent amounts for vacant units after a vacancy factor reduction* (consider local demographic trends of population density and personal income as they influence future rental income);

- operating expenses, including taxes, maintenance, repairs/replacements and all other management costs –information which helps anticipate operating expenses includes the age, quality and care of the structure and components);and

- the CAPITALIZATION RATE the buyer devises as appropriate to evaluate property of its type and condition.