The Cap Rate Part 1: What It Is, What It Does

Again, a reminder that postings on this blog site are sometimes aimed for those who are new to the real estate development industry or who are interested in learning more about it. This is one of those postings.

In an earlier blog, we discussed the concept of cash-on-cash as a means of measuring return on equity capital invested in a real estate project. Most real estate development capitalizations, however, include debt as well as equity.

In the current market, debt often provides 50% to 70% of the development capital needed. The balance generally is raised in the form of equity - money invested by individuals or entities with the expectation of profit or return of, as well as on, the investment. These are financial partners, not lenders who provide debt capital. Some sophisticated forms of debt can be converted to an equity position. Some may require participation in addition to interest on the debt capital. These arrangements sometimes are referred to as “equity Kickers”.

While cash-on-cash is a measure of return on equity, the capitalization rate, or cap rate, measures return on total capital invested: debt as well as equity. So, it is a measure of 100% of the capital utilized to develop or acquire an income producing property. In simple terms, it is the estimated rate of return on the capital invested in an income generating property at the time of its purchase or the initial stabilized year. It is expressed as a percentage.

For example, suppose a property generated net operating income, or NOI, (total income minus vacancies, credit losses, and operating expenses) of $500,000. Suppose also that the total capital (debt and equity) required to acquire the property is $7,500,000. The cap rate is 6.67%.

Cap Rate = $500,000/$7,500,000 = .0667 or 6.67%.

Thus, a common way the cap rate is used is as a means to identify investment properties that meet the investor’s desired rate of return. The investor analyzes the probable purchase prices of various properties and their respective NOIs. Using the formula above, it is easy to determine whether a given property meets the investor’s hurdle rate (minimum acceptable rate of return. In the example above, if the hurdle rate was 6.68% or higher, the investor probably would pass. If the hurdle rate was 6.67% or lower, the investor might be interested.

Instead of purchasing an existing income property, suppose you were going to develop one. If the total cost to develop it, including land, was $7,500,000, and it was expected to generate NOI of $500,000 in the initial year of operating after reaching stabilization (achieving the pro forma rents), the cap rate would be 6.67%, as demonsrated above.

In the next blog on cap rates, we’ll go into more detail.

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