What Does Cap Rate Mean in Real Estate

 This question comes up a lot in real estate. Old pros or new to the industry will find it worth the effort to understand what it means. The full term is capitalization rate and is often referred to as 'cap rate'. It is used to describe property valuations, in real estate models, and as a general communicative term in the industry.

Cap Rate Calculator: https://docs.google.com/spreadsheets/d/1UK7OCgWw0z4YvP7gQcUP__W4v02Jb_bo/edit#gid=1459549819

Real Estate Spreadsheets / Underwriting Tools: https://www.smarthelping.com/p/real-estate.html

Cap rate simply means the percentage of the purchase price of a property that is earned in Net Operating Income (NOI) per year (assuming NOI never changes). 

For example, if you bought a property for $8,000,000 that was doing $300,000 per year in NOI, the CAP RATE is equal to $300,000 divided by $8,000,000 which equals 3.75% and that means every year, 3.75% of the $8,000,000 purchase price is earned back in NOI ($300,000). 

In the above case, it would take ~26.6 years to repay the purchase price if the NOI never changed. This does not take into account any debt service or debt funding.

You can see why the term 'cap rate' is used when describing real estate deals and in analysis. It gives perspective by using a term that is generally accepted and known.

In relation to real estate modeling, there is 'going-in cap rate' which just means the current property NOI without making any changes divided by the purchase price. There is also an 'exit cap rate' which is just the cap rate upon exit based on the final year NOI of the model.

There are a few ways to define the value of a property within a financial model. The two most common are defining a yearly appreciation in property value and then comparing that value to the NOI each year to see the resulting cap rate or (the way I do it) is by defining the exit cap rate and letting that drive the property value at some point in the future based on expected changes in rents / expenses (NOI) over time.

Note, depreciation is not counted in Net Operating Income (it is a non-cash item) and will not effect the cap rate in any way.