Capitalization Rates - What Are They, Why Are They Important and Where Are They Heading

If you are planning to be a real estate investor, you need to understand capitalization rates (cap rates), how they are calculated and why they are important. In order to understand cap rates you also need to understand the concept of net operating income (NOI).

If you are a seasoned real estate investor, you already know that the amount of money generated by a property after deduction of expenses and before debt payment is the Net Operating Income. To calculate the cap rate of a property offered for sale, you divide NOI by the Sales Price the result of which is expressed in percent. Here is an example:

NOI = $20,000 and Sales Price = $250,000

$20,000/$250,000 = 8% or an "8 Cap"

You can also calculate what a selling price should be if you want to achieve a certain cap rate and you know the NOI. From the example above:

$20,000/.08 = $250,000

Why is this important? It is a way of looking at relative value in real estate investments (and other alternative investments for that matter). Think of it sort of in the way that you think of the Price/Earnings Ratio of a stock which is the stock's Share Price/Earnings Per Share. This is one way to look at the relative value of stocks (there are a whole bunch of other ways, but that's a different topic).

Say I want to buy an income property and it has the assumptions from above. Let's say there is another property for sale for a 9 cap. The price of that property if it produces the same NOI will be $222,222 ($20,000/.09). So a higher cap means a lower price and a lower cap means a higher price. Until an investor gets used to making this calculation, there is a natural tendency to get the answer backwards so if you are investing in real estate you should practice these calculations until they come naturally.

On to the next reason why this is important. A major advantage of investing in real estate is that debt can be used for leverage. As a real estate investor, I want my cap rate to be above my cost of money. Using the example from above again, if I can finance my real estate purchase for 7% then I have a positive spread. If I have to borrow money at 10%, I am counting mostly on appreciation to make money. This happened a lot in the previous years during the real estate bubble. I can't tell you how many times I had to talk people out of buying properties in Chicago three or four years ago for cap rates of 4.5 when their cost of money was 6.5%.

Where are cap rates heading? My view is that they have turned the corner and are heading down. This seems to be particularly true for multi-family investment properties. During the recession, cap rates for all real estate asset classes headed North (meaning prices dropped) and now that they are turning the corner and starting to go South, the prices are going up. See what I mean about the tendency to get this concept backwards? Cap rates are heading South (going down) so prices are heading North.

If you want to learn more about this or have questions about the concept, feel free to contact me. For more real estate news and tips, visit and subscribe at http://chicagolandrealtor.blogspot.com/