Please who can explain capitalization rates (cap rates) in finance?

Question

(First off, whoever came up with the forum deserves a lifetime supply of oven-fresh cookies. I personally find it helpful in learning.)

The best explanation I’ve come up with so far (I’ll be updating this as I gain more clarity)

“When you want to grow your money, you can do that by buying an asset (which could be a business, piece of real estate, etc). Before you buy an asset, it helps to have an idea of the VALUE of the asset.

“One of the ways to find out the value of an asset is by comparing how much income it actually brings in every year with how much the asset cost you to buy. This is the capitalization rate, shown in a formula:

Annual earnings / Asset cost

Capitalization rate is a number that quickly tells you how much per income dollar your asset is costing you. Thus, a low cap rate means you are getting more value from the asset”

Please what else am I missing?

In: Economics

Answer 1

For real estate a cap rate is an income approach to value. In a 10% cap rate market investors are paying $10 per dollar of possible NOI. In a 5% cap rate market investors are paying $20 for that exact same dollar of NOI. It is a valuation metric not a return.

So $50,000 on NOI will sell for $1,000,000 at a 5% cap rate in San Francisco and $50,000 NOI in Indianapolis will sell for only $500,000 at a 10% cap rate. Uninformed people or scammers will try to convince you that a cap rate is a return so they can sell crap properties in crap markets.

Now why would the same NOI sell at such different prices? Well even though the NOI only looks at one years NOI investors look with a longer lens. In San Francisco you will probably see rents increase much more than in Indy so your property will be more in the future because the NOI will be larger. Also cap rates do not account for capex. In Indy where rents may be 25% of what they are in SF you will need maybe 4 times the square feet to get to $50,000 NOI. Think of all the capex that is based on SF, roofs, carpet, paint, HVAC, etc. All of those expenses will come out of your NOI. Don’t be fooled into thinking cap rates are anything other than a valuation metric.