The CAP Rate is one of the primary tools of measuring value of an income producing property. The formula for calculating the rate is as follows: Net Operating Income ÷ Cost = CAP rate
In simpler terms, CAP rate is very much like the interest rate one might receive on a CD at the bank. Obviously, holding real estate carries greater risk than an FDIC insured Certificate of Deposit, so the CAP rates on real estate typically carry much higher rates.
Net Operating Income is pre-tax income and only includes tangible expenses and revenues. In other words, interest, depreciation and amortization are not considered.
General Rules of Thumb with CAP Rates:
- There is an inverse relationship between CAP and value. The higher CAP rate at which you purchase any given property the lower the value of the property.
- Higher credit rated tenants can drive down the CAP rates and increase values.
- All other things being equal, the longer the lease, the lower the CAP rate
- The lower the risk (chance of lease renewal, location, tenant, economy, etc) the lower the CAP rate
- Superior locations and frontage of busy roads have a tendency to lower CAP rates
- Deferred Maintenance (items which should have been repaired, but have not yet been addressed) tends to drive higher CAP rates.
- CAP rates are heavily influenced by the yield on 10 year US treasury notes.
- With McDonalds as a 20 year tenant, an identical property will sell at a lower CAP rate than the identical lease for a profitable Regional Mattress retailer. The profitable Regional Mattress retailer will sell at a lower CAP rate than the identical property & lease with a local start up coffee shop as the tenant.
- A McDonald’s lease with 20 years remaining on the term will probably sell for a lower CAP rate than the identical property with only three years remaining on the lease to McDonalds.
- When a landlord is making a decision of choosing between McDonalds and a local start up coffee shop as a long term tenant, there could be a 6 percentage point difference between values of the property with the two different tenants. (Net Operating Income = $200,000 per year. McDonalds as tenant = $4,000,000 at a 5% CAP. Local Coffee Shop as tenant = $1,818,000 at an 11% CAP )