As a real estate investor, both active and passive, it's important you understand the cap rate. It's a term you'll hear a lot and in a lot of different contexts. The most concise way to think about the cap rate is as the un-levered rate of return on an investment. By definition, the cap rate is a percentage that equals the annual net operating income of a property divided by the purchase price:
[NOI / Cost = Cap Rate]
So a property for sale for a million dollars that produces an NOI of $100K/year would be a "10 cap":
$100K / $1m = 10%
As a reminder, the net operating income is the amount you have left over after subtracting your operating expenses from your gross income. It's basically what the investment will earn you before your mortgage and any capex (those one-time expenses that increase the life of your asset such as roofing or interior upgrades).
One thing to be aware of is that there's an inverse relationship between the cap rate and the purchase price. So as a buyer, you're looking to purchase at a higher cap rate (all else being equal - a big caveat).
Simple enough. But the cap rate is much more than a number - it does a lot of work in a variety of contexts. Let's go through a few here.
Market comps: The cap rate is often used in the aggregate to represent how much investors are willing to pay for a particular type of property in a particular market. E.g. "C-class properties in the Raleigh area are at a 6 cap" means that in the Raleigh area investors are willing to pay $100K for every $6K/year in NOI a C-class property generates.
Risk: If you have two assets that produce the same NOI it stands to reason you'd be willing to pay more for the less-risky or higher quality one, right? So lower cap rate assets (which equates to a higher purchase price) _should_ be less risky on a relative basis.
Pricing indicator: You will often hear the cap rate being used by brokers as a shorthand way to relay the pricing expectations of their seller. For instance "she's looking to hit a five and a half cap" is the broker's way of saying the seller expects to get a sale price roughly equal to 18x the annual NOI.
If you've got your head wrapped around the various uses of the cap rate, now would be a great time to throw another wrinkle into the mix – there are different types of cap rates! The underlying formula is the same (NOI / Price), but it can be used to represent a few different stages of the asset lifecycle. Here are a few:
Purchase cap rate: This is the default and the easy one. This is the NOI at the time of purchase divided by the purchase price.
Pro forma cap rate: For value-add investments where there's expected to be an initial period of forced appreciation you might hear the broker talk about the pro forma cap rate. This is the *expected future NOI* divided by current price. It's meant to show what you're getting once you capture the known appreciation opportunity (but don’t get too mesmerized by this cap rate - YOU should be rewarded for your efforts, not the seller).
Operating cap rate: This is the current NOI of a property divided by the purchase cost. For instance, if you’re in year two of your ownership you would take your year two NOI and divide by your purchase price. This cap rate is useful when looking at a potential sale. If your market is at a 6 cap and you’re operating at an 8 cap then that difference is what you can expect to capture when you go to sell.
This is just a taste of what a cap rate represents. As you can see, it's an overloaded number but is important to understand since it’s an integral part to how commercial real estate investors talk about opportunities.
Another thing to keep in mind is that a cap rate is not the end-all be-all. Just because your market is a 6 cap and you see a property listed at an 8 cap doesn’t mean it’s a screaming deal (the inverse is also true). There are so many variables to the potential of a property there can never be a single number that captures its value. Always dig at least one level deeper when evaluating a property.