The Cap Rate is a core ratio in commercial real estate investments and is very useful because it is so simple. All you really need is a reliable 1-year Net Operating Income (NOI) number. For this reason it is often used to create a beginning purchase price and ending sale price. Also, it can be used as a Return on Investment (ROI) or Profitability Ratio as shown in the example above. Use of the Cap Rate to create a beginning purchase price or an ending sale price Net Operating Income (NOI) is part of the Cap Rate, and it is important to understand which NOI is being used --- Last Years, Next Years, or a 'Current Year' NOI created by multiplying the current month by 12? Use of each of these NOI values has issues:

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Capitalization Rate
for commercial real estate
investments and developments

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Why is Capitalization Rate useful
for commercial real estate?
The Cap Rate is a core ratio in commercial real estate investments and is very useful
because it is so simple. All you really need is a reliable 1-year Net Operating Income
(NOI) number. For this reason it is often used to create a beginning purchase price
and ending sale price. Also, it can be used as a Return on Investment (ROI) or
Profitability Ratio as shown in the example on another slide.
Use of the Cap Rate to create a beginning purchase price or an ending sale price
Net Operating Income (NOI) is part of the Cap Rate, and it is important to understand
which NOI is being used --- Last Years, Next Years, or a 'Current Year' NOI created
by multiplying the current month by 12? Use of each of these NOI values has issues:

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Which NOI should be used for the
Capitalization?
Last Year's NOI is virtually never used to create a beginning purchase price, but is
often used to determine ending sale price. The argument in favor of this use is that it is
a more "conservative" valuation method. However, if a prospective buyer were to be
valuing the property at the date of sale, he/she would most certainly be looking at an
APOD showing either the Current NOI at the sale date or the Next Year's NOI,
together with the corresponding Cap Rate. Since that would be the buyer's perspective
at that time, I believe the property's projected sale price should be determined using
either of those NOI values.

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Which NOI should be used for the
Capitalization?
'Current Year' NOI (created by multiplying the current month by 12) is typically shown
as the NOI (and used in the Cap Rate) in the APOD report. This NOI value has the
advantage of taking the cash flow of the current month and looking at the next year
without seemingly making any assumptions about the next year. However it does
implicitly make the assumption that all the NOI components during that month continue
for the whole year. For instance, all the vacant spaces are assumed to stay vacant, expenses
don't escalate, and so on. When the Cap Rate is being used to determine a future sale
value, this method makes it more difficult to understand where the sale value number is
coming from, since you need to see the monthly number to recreate the 'current year' NOI.
For self storage and apartment type properties with lots of turnover this might be the most
accurate estimation method for future sale price, but for office and retail properties, where
projected vacancies occur irregularly due to lease expirations, use of a single month's
projected NOI can lead to false sale value projections.

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Which NOI should be used for the
Capitalization?
Next Year's NOI is typically used to determine a ending sale price for a property
projection. More rarely, it may be used as the NOI for a Cap Rate used for a current
sale price. When used for a current sale price, it must make assumptions about the
revenues and expenses to be expected during the next year, which can be problematic.
When used for an ending sale price, such assumptions must also be made, but making
them may well be the best available method of valuation (particularly for leased
properties such as office and retail investments.

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Capitalization Rate
Considers / Ignores
• Considers: Price, Scheduled Income(Current Year Only),
Vacancies (Current Year Only), Expenses (Current Year Only)
• Ignores:Time Value of Money, Sale Proceeds, All Financing
(Loans), Other Years NOI, All Taxes
... and a lot of other things

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• Price
• Expenses
• Revenue Items (Rent Increase/Decrease,
Vacancy, Reimbursements, Free Rent)
What is the Cash on Cash
Sensitive to?

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Capitalization Rate Example
2010 Net Operating Income (NOI) $276,987
divide by the Price $3,300,000.00
equals the 2010 Cap Rate 8.39%
2010 2011 2012 2013 2014 2015
Total Gross Income $365,472 $372,443 $370,410 $376,040 $384,217 $414,321
Less: Vacancy & Credit Loss 19,084 3,202 14,620 5,049 3,501 50,321
Effective Income $346,387 $369,241 $355,790 $370,992 $380,717 $364,000
Total Operating Expenses $69,400 $71,244 $73,141 $75,094 $77,103 $79,170
Net Operating Income $276,987 $297,997 $282,649 $295,898 $303,614 $284,830
Capitalization Rate 8.39% 9.03% 8.57% 8.97% 9.20% 8.63%

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Watch Video
about Capitalization Rate

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