What is a cap rate?

I wanted to talk briefly about some important, but scary sounding concepts. If you have entered into the commercial real estate world at all, then you know all about what a cap rate is and what it means for valuation of a commercial asset.

If you have not entered into the commercial real estate world and would like to or at least want to know a little bit more about it... Cap stands for Capitalization Rate and as complex as it sounds, it's pretty simple. This means it is the un-leveraged return-on-investment. The way you find out what the cap rate is by knowing the net operating income for the the amount of money the property is making - all of the expenses except for your mortgage. So you divide the Net Operating Income by the total purchase price. For example, if you have a million dollar property that makes $100,000 after expenses, but before your interest for bank payment, that would be a 10 cap because the un-leveraged rate of return is 10% of that. However, what gets confusing is it's actually a way to Value various properties. 

So a broker may come to you and say you know broker may come to you and say there's a property and it's trading for an eight cap. That means that whatever the purchase price of the may not even tell you what the purchase price is. They expect you to figure it out with a little calculation. Whatever the Net Operating Income is divided by 8 percent, that will give you the purchase price. That is a little foray into commercial real estate.

A lot of people are talking right now about how cap rates are compressed. That means that people are buying commercial real estate for a lower cap rate, which sounds like a good thing, right? The cap rate is going down, but because of that calculation, the price is going up exponentially, not just as a factor of one to one. It's a multiple. The lower the cap rate, the way higher the price is going and that's what's happening right now. There's a lot of money out in our economy right now where a lot of commercial real estate is trading hands and the price is going up dramatically. So that's what they mean when they say the Cap Rate is compressing whereas things used to trade for 9-10 caps today. Those same assets are trading for 6 to 7, or 5-6, and in some markets like San Francisco and New York things are trading as low as 3-4, which means they are very expensive and not producing a great return. This doesn't mean that real estate is not a great investment still, it's all about buying a good deal and they're still out there. Just got to find them.