Capitalization Rate

If you're a commercial real estate investor (or aspire to become one), here's a key metric to keep in mind: capitalization rate (or "cap rate" to its friends). It shows the relationship between the Net Operating Income of a property and its overall value.

Let's say an office building sold for $20 million with an established net operating income of $400,000 a year. (Think of NOI as just pretax profits in running the building after all of its operating costs). So the capitalization rate in this case would an enormously expensive 2%. That is, the buyer paid $20 million for $400,000 in operating income...or 50 times that rate. Crazy expensive.

Cap rates exist as a vehicle with which to compare property investments. However, the cap rate alone doesn't tell the whole story. In most cases, the location of the building, its occupancy rate, the cost of debt on or attached to the building matters a lot.

The crazy cap rate of 2% that we talked about before might be cheap if the building was only half rented and the buyer was about to raise rent 30 percent on the existing tenants and bring in 30 more renters to "overnight" make NOI closer to $5 million than the $400k at which the building was running.

Cap rates represent a standard pricing metric in the industry. Think of the figure as analogous to the price per square foot in residential real estate. You could also use cap rates to look for trends in the commercial real estate market. If cap rates are going down, it most likely means values are going up, and if cap rates are going up the trend might be headed to lower market values. ​