Cap Rates…Some Like It High…Some Like it Low

There are really two perspectives when looking at capitalization rates in business–the buyer’s and the seller’s. Why would one want it high and one want it low. Before explaining their differing perspectives, it is first important to understand what we mean by “capitalization rate” or “cap rate.”

A capitalization rate in business is the ratio between NOI or net operating income and value or cost. In layman’s terms, it is the expected rate of return on monies invested. The formula can be twisted and turned to give a couple of values and indicators.

The standard formula is the following:

               Capitalization Rate =  Net Operating Income /
                                                                      Value (Cost)

In looking at this formula, if you know the NOI and know the value of a business or cost to buy the business, then you can determine the capitalization rate. What does that really get you, though? Well, it lets you know what the anticipated rate of return is on monies invested in the business.  It also helps to give you a means of comparison to other businesses in that particular industry.  In some industries, for example, a cap rate of 10% is considered good, while in others it maybe considered too low for the risk involved.

A case in point, in the healthcare industry, an acceptable  cap rate for an assisted living facility maybe 10%, while a skilled nursing facility would need to yield 13% to create interest in a potential buyer, due to the tighter margins and risk.

Another way the formula can be used is to determine a value when the NOI and the acceptable or expected rate of return is known.  In this case, the formula is adjusted:

                       Value (Cost) =  Net Operating Income /
                                                                Cap Rate

Capitalization Rates In Business

For example,  said you want to buy a retail building.  The seller indicates that the building throws off an NOI of $150,000.  You, as the buyer, understand that a reasonable rate of return on such a building, given the industry and market conditions, is 10%.  As a result, the value or cost you will comfortable with is $1,500,000/.10 = $1,500,000.

Capitalization Rate In Business

So, why do some like it high and other like it low?  I once heard someone say that a 10% cap rate is good. Well, it is all a matter of perspective.

A buyer likes to see a high cap rate, since they want a high rate of return–in the formula, the higher the cap rate, the lower the cost.  The seller hopes that the buyer does not want a high rate cap, since the value (or money they will receive) will decrease as the cap rate goes up–they hope the expected cap rate is low.

Views of real estate and business, just like a lot of things in life, are matter of perspective and where one stands. The capitalization rate in business allows both parties to at least use the same method to measure. (Credit to Keith Basik)

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3 Comments

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3 responses to “Cap Rates…Some Like It High…Some Like it Low

  1. Thank you Izzy. We have developed an algorithm for residential real estate cap rates. Most residential real estate investors or regular primary residence home buyers don’t use cap rate as a key indicator when purchasing but we feel it is relevant for resi real estate too…
    What are your thoughts?

    • Bill,

      Thank you for your input. It is relevant but it is only one of key indicators. Many issues come into play, but a cap rate is certainly
      an important component.

      Iz

      • Yes agreed, one of many. We also allow our users to search by cash flow. We found that it is important for regular home buyers to know if they can rent the home out for the payments incase they lose their job or end up getting relocated. In future releases advanced users can also search by GRM, ROI, Equity, cash on cash return, and debt service ratio.

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