What is a Cap Rate

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The cap rate is the return expected by a buyer of commercial real estate.

People who buy commercial properties naturally intend to make a profit. This of course also applies to Real Estate Investment Trusts. REITs will likely be looking at different properties, and will need to choose. The capitalization rate is one tool for comparing properties on an apples to apples basis.

Cap rates are expressed as the expected cash flow (or net operating income) divided by the purchase price. (Cash flow does mean cash flow, not net income according to Generally Accepted Accounting Principles, which is reduced by depreciation. Cap rates are figured without using depreciation.)

If the price of a office building you're looking at is $10,000,000, and you can expect to receive $50,000 from it in a year, the cap rate is 5%.

Compare the Property's Cap Rate to Your Cost of Capital

If you have to pay 6% interest to borrow the $10,000,000 -- you cannot afford to buy this building. You can't overcome the hurdle rate of return you need to make this transaction profitable for you.

If you can find the $10,000,000 for only 4%, maybe it's a good deal.

Therefore, capitalization rates are influenced by prevailing interest rates in the economy. An investor cannot make a profit of the cost of capital is too high.

If you own the office building in the above example, you will have to come down on your asking price if no potential buyer can get a loan at less than 6% interest. That would mean nobody could afford to buy your building. You've priced it too high.

Market Cap Rates Determine Commercial Property Values

Property buyers also will demand higher cap rates the more risk there is in buying the real estate commercial property.

This is using the Income Approach (including the theory of Capitalization) to appraising property.

Nominal cap rates exclude ordinary and normal expenses that are often capitalized (replacement carpeting, for example), but which don't really add to the value of a building.

The effective cap rate or the economic cap rate does use these expanses in calculating net operating income.

Next: What are Funds From Operations -- measuring cash from the business

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