Cap RateWhat is a cap rate, and what does it tell an apartment owner?

What is a cap rate?

Cap rate, short for capitalization rate, compares what a property earns in a year to what it costs to buy. It is the first number most buyers, brokers and lenders look at when they size up an apartment building.

Because a cap rate ignores the loan, it lets you compare properties on the same footing no matter how each one is financed. A higher cap rate usually points to more income for each dollar of price, and often more risk, an older building or a weaker location. A lower cap rate usually means a steadier property that buyers are willing to pay more for.

The cap rate formula

Cap rate = net operating income / purchase price

The top of the formula is net operating income: the rent and other income you actually collect, minus operating expenses, before any loan payment. The bottom is the price or current value. Turn the formula around and you get value: NOI divided by the cap rate.

A worked cap rate example

Illustrative figures, not from a real property

Say a 60-unit building produces $500,000 of NOI a year and is offered at $8,000,000. The cap rate is $500,000 / $8,000,000, or 6.25 percent.

Now say the owner raises NOI to $550,000 and buyers still price similar buildings at 6.25 percent. The value becomes $550,000 / 0.0625, or $8,800,000. That is why owners focus on NOI: at a steady cap rate, each added dollar of income adds many dollars of value.

What a cap rate does not tell you

A cap rate is a snapshot, not a forecast. It depends on the NOI used, so check whether the number comes from the seller's projections or from actual results such as the trailing twelve months. If you are unsure what is a T12 in real estate, start there before you trust a quoted cap rate.

It also says nothing about deferred repairs, the cost of leasing up a vacant building or what your loan will cost. Pair it with cash-on-cash return to see the effect of financing, and with yield on cost when you plan to renovate. To run the numbers on your own building, try our cap rate calculator, and read what is a good cap rate for how buyers judge the result.