The capitalization rate—or cap rate as it is commonly called—is the most ubiquitous metric in commercial real estate investment. Once you dip a toe into the CRE investment pool, you hear those two words a lot. While fundamentally, a cap rate is simply the yield or return on your investment, it can play an integral role in guiding the structure of your deal and in determining asset pricing. Institutional owners live and die by the cap rate profile on their portfolio, but small and independent owners don’t rely on the metric as often. Sometimes, that’s fine, depending on your investment goals. However, cap rates can play a crucial role in helping you to better understand your portfolio, maximizing returns, and deciding where to invest next.

First, what is a cap rate?

A cap rate is simply the rate of return on an investment. So, if you have a 5% cap rate, the rate of return on your property is 5%. To calculate the cap rate, divide the annual net operating income ("NOI")—the operating income after deducting maintenance, property taxes, insurance, management fees, and any other costs—by the total acquisition cost, which includes the asset price as well as any brokerage fees, closing costs, and renovation costs.

For a $2,000,000 apartment building with a net operating income of $100,000 annually, the cap rate is 5% (or 100,000/2,000,000).

Keep in mind that this formula does not factor debt or mortgage payments on the asset, and as such the cap rate represents the un-leveraged rate return. That gives investors an equal playing field to compare investment assets apples-to-apples.

Putting cap rates to work

A cap rate gives you a baseline to compare investments. You can use it to stack up potential apartment acquisitions, compare geographic markets, analyze different CRE asset classes and even compare different investment assets, like securities, to best decide where to allocate your capital.

Cap rates are also a representation of risk, so it isn’t as simple choosing the investment or asset with the highest cap rate. Properties and markets with higher risk will generally have a higher cap rate to compensate for that risk. Las Vegas apartment properties are naturally going to have higher cap rates than comparable properties in San Francisco, for example, because Las Vegas is a riskier market.

Instead, cap rates are best used to make nuanced comparisons and to track market trends that can ultimately lead to better investment decisions. There are several other factors that, when considered together with the cap rate, will help provide a more complete picture of an investment’s viability. These include occupancy trends, rent upside and growth, tenant mix and profile, financing terms, and capital expenditure outlay, among many other factors.

Determining asset value

Perhaps even more importantly for independent investors, cap rates are a tool to evaluate and understand fair asset value based on the asset’s income.

In a rent-controlled market, an apartment building could produce an appreciably different rent roll and therefore a different NOI than the building next door. Or, a poorly managed property might have a high vacancy rate or mismanaged funds, driving down the NOI. To achieve the right cap rate for the market, the property with a lower NOI will also have a lower price tag.

Property one generates $100,000 in NOI annually and is sold for $2,000,000, producing a 5% cap rate.
Next door, property two is the same size and quality; however, it only generates $90,000 in NOI annually due to poor management.
Using the same cap rate of  property one, the owner of property two will list the property for $1,800,000 or $200,000 less than property one.

The opposite can also be true. If NOI is equal, a higher cap rate yields a lower asset value. Apartment assets with identical net operating incomes might produce a different cap rate to account for differences in the asset quality or the surrounding market conditions. This usually happens when comparing assets in different neighborhoods or comparing different asset classes, but even neighboring buildings can have different risk assessments that are priced in through a higher cap rate.

Cap rates and debt service coverage ratio

While cap rates don’t account for debt on an asset, they can play a vital role in determining the structure of your deal and the loan-to-value. Similar to a cap rate, lenders use a debt service coverage ratio ("DSCR") to determine if a property’s income will support both the operating expenses and the debt payments. In the same way that institutions will set a cap rate limit on investments, lenders will set a DSCR limit. To calculate the DSCR, divide the NOI by the total debt service.

If the DSCR does not meet the lender’s requirements, the borrower will have to take a higher equity stake in the property, resulting in a lower loan-to-value ("LTV"). Cap rates at 4% or 5%, which are not uncommon in a primary market like San Francisco, will generally require a lower LTV to meet the lender’s DSCR requirement.

A $1,200,000 loan representing a 60% LTV at a 4% interest rate and 30-year amortization period would dictate annual mortgage payments of approximately $69,000. This would yield a 1.45x DSCR ratio ($100,000/ $69,000.)

Looking beyond cap rates

While cap rates are an important metric, they aren’t the only metric to consider. Beyond cap rates, an internal rate of return and a cash-on-cash return are also common ways to calculate the rate of return on a real estate investment.

An Internal Rate of Return ("IRR") is a complex metric that estimates the future profitability of an investment. Like a cap rate, you can use an IRR to compare different investments and investment assets on an apples-to-apples basis, and a higher IRR is considered more desirable.

A cash-on-cash return represents the return on an investor’s equity investment in an asset. To calculate a cash-on-cash return, subtract the annual debt service cost from the NOI, and divide the result by the total cash invested in the asset, including the down payment, closing costs and renovation costs. The result will give you the return, including debt service, on the capital invested in the asset. Because cash-on-cash returns include the debt, it is not a good method to compare investments on an apples-to-apples basis.