Capitalization Rate (Cap Rate)
The capitalization rate or “cap rate” provides an indication of the return that a commercial real estate investor can expect in an all-cash purchase and can be used to compare the price of one property to another. The cap rate is calculated as Net Operating Income (see term #2 below) divided by the property’s asking price, and the result is expressed as a percentage. For example, a property with $100,000 in Net Operating Income and an asking price of $1 million has a cap rate of ($100,000 / $1 Million) 10%. Put another way, if an investor purchased this property with $1 million in cash and earned $100,000 in the first year, they would earn a return of 10%.
Net Operating Income (NOI)
Unlike residential real estate, which is valued on comparable sales, commercial real estate is valued based on the amount of “Net Operating Income” or “NOI” that a property produces.
Net Operating Income is calculated as a property’s Gross Potential Rent; less operating expenses and it is expressed as a dollar figure. For example, if a property produces $250,000 in Gross Potential Rent and has $150,000 in operating expenses, the resulting Net Operating Income is $100,000. To estimate value, a Cap Rate can be applied to NOI. For example, if a 10% Cap Rate is applied to $100,000 in NOI, the resulting value estimate is ($100,000 / 10%) $1,000,000.
Internal Rate of Return (IRR)
The Internal Rate of Return is another return metric that provides an investor with a property’s annual compound rate of return. Mathematically, it is the discount rate that sets the Net Present Value of all future cash flows equal to zero.