CAP RATES is a shorthand term for “Capitalization Rates,” a highly used metric in the financial and real estate world on an international level. Through CAP RATES, financial analysts, bankers, developers, investors, and other key players in this dynamic industry can quickly assess and compare the value of a real estate property based on the income it generates.
The use of the CAP RATE as a tool to estimate and compare the value of real estate properties falls under the umbrella of relative valuation methods, in which a reference indicator is applied to the business’s earnings to produce a preliminary value estimate. However, unlike other reference indicators that function as multiples, the CAP RATE is expressed as a percentage (%).
In other markets, it is common to have publications and services that monitor the CAP RATES at which different types of real estate properties have been transacted. These rates are then used as reference points to estimate property values when considering the purchase or sale of a property based on the income it generates.
The CAP RATE is the result of dividing the annual Net Operating Income (NOI) of a property by its acquisition value. For example, if we purchased a commercial space in the corner plaza for RD$10,000,000 and leased it in a way that generates RD$800,000 in net operating income per year, we can say that the CAP RATE of our property is 8%. Net operating income is determined by subtracting the operating costs of the property—such as insurance, administrative expenses, maintenance, utilities, and other related expenses—from the rental income it generates.
Similarly, if we were evaluating the opportunity to invest in a beachfront apartment that we know generates RD$1,000,000 in annual net operating income, and we are aware that CAP RATES for properties in similar tourist areas are around 10%, we can estimate the value of the apartment at RD$10,000,000, which is the result of dividing the annual net income by the CAP RATE.
CAP RATES can vary by location between different regions, cities, districts, and even specific sectors within the same urban area. They can also vary between different types of real estate properties, such as residential, office, industrial, hotel, and commercial properties, among others. In general, low CAP RATES indicate lower investment risk, while high CAP RATES are representative of higher-risk alternatives. For example, properties located in the most exclusive areas of an urban zone, with lower volatility in their occupancy rates, tend to be transacted at lower CAP RATE levels compared to properties in urban areas prone to higher volatility and insecurity regarding occupancy rates. Tenant quality can also be a risk factor reflected in a property’s CAP RATE. For instance, properties occupied by tenants with an excellent payment history tend to be transacted at lower CAP RATE levels compared to properties with tenants who have a questionable payment record.
The CAP RATE is an easy-to-use metric that has become very popular in the financial real estate world as a quick method for evaluating and comparing investment opportunities in real estate assets. However, it should not be used as the sole evaluation tool, as there are multiple factors not accounted for when using this simplified tool. Finally, it is important to highlight that the CAP RATE does not represent a discount rate or cost of capital. Instead, it can be considered an indicator used to make relative value estimates for real estate properties, similar to how earnings multiples are used to estimate the value of a business.