“Cap Rate”…What’s that?

March 2, 2021

If you are new to commercial real estate investment, you are probably hearing the term “Cap Rate” used a lot and maybe wondering what it is and how it is used within commercial real estate.

The “Cap Rate” or Capitalization Rate is a popular valuation metric used to determine the value of an income producing asset such as RV Parks or Self Storage. It is calculated by dividing the Net Operating Income by the Purchase Value or Market Value of an asset. For example, if a storage facility has a Net Operating Income (NOI) of $100,000.00 for the previous 12 months and the owner is asking $1,500,000.00 for the asset, then the Cap Rate is 6.67%. This is known as the “Actuals Cap Rate” because it based on the actual performance of the asset.

Sometimes you will hear the term “Pro Forma Cap Rate”. This is used for properties that may need a new owner to increase occupancy, rates or improve the property in some way after purchase. So, the Pro Forma Cap Rate is showing the asset’s potential once these improvement items have been accomplished by the new owner. The Pro Forma Cap Rate is calculated using a potential/future NOI (usually Year 1 or 2) and dividing that by the purchase price.

You may have noticed that the Cap Rate is calculated the same way as Return on Cost (ROC). As you own the asset and improve upon the property you want your Cap Rate or ROC to increase. However, when you go to sell you will use a market-based Cap Rate for that asset type to determine the value based on NOI.

For example, I may own a Class A self-storage facility located in a primary market area such as Austin, TX. The facility is a stabilized, 100,000 net rentable square foot climate and non-climate storage facility built in 2015 with all the latest security, energy saving features and technology available. It also has great frontage on a major thoroughfare. For that facility the market is paying a 6% cap rate aka “6 cap”. If the facility has a trailing 12 NOI of $600,000.00, then you can figure the market might pay $10,000,000.00.

We hope you found this article helpful! Please contact us today if CRD Realty can assist you with selling or buying your next commercial real estate asset.



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