The capitalisation rate (cap rate) links a property's income to its value: cap rate = NOI ÷ value. A building with $600,000 of NOI that sells for $10,000,000 traded at a 6% cap rate. It's the yearly return you'd earn on an all-cash purchase, before any growth.
Turned round, it's how income properties are valued: value = NOI ÷ cap rate. Appraisers and lenders take the NOI and a market cap rate, from recent sales of similar properties, and divide.
noi = 392_000
for cap in (0.055, 0.060, 0.065, 0.070):
print(f"{cap:.1%}: ${noi / cap:,.0f}")5.5%: $7,127,273 6.0%: $6,533,333 6.5%: $6,030,769 7.0%: $5,600,000
Lower cap rates mean higher prices for the same income. Investors accept a lower cap rate when the income feels safer or likely to grow: a newer building, a strong location, long leases to sound tenants. They want a higher one for older buildings, weaker markets or riskier income. Cap rates also tend to rise when interest rates do, because buyers can borrow less cheaply.
Small moves are big. At $392,000 of NOI, going from a 5.5% to a 6.5% cap rate takes the value from about $7.1 million to about $6.0 million, a fall of about 15%. That's why lenders worry about cap rates rising during a loan: the property can be worth less than the loan even though the rent didn't change.
A cap rate is only as good as the NOI it's applied to. A low cap rate on an inflated seller's NOI double-counts the optimism. Use underwritten NOI.
NOI is $750,000 and the market cap rate is 6%. What's the value, in dollars?
| Cap rate | NOI ÷ value. |
|---|---|
| Value | NOI ÷ cap rate. |
| Lower cap rate | Higher price for the same income: safer or growing income. |
| Cap rate expansion | Cap rates rising, so values fall. |