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1 min read

The Simplicity of Cap Rates

Simple things are appealing. They provide a layer of abstraction between you and the underlying complexity. The iPhone is a sophisticated device, though it appears less complicated. A large part of its success is that you're not burdened by the involvement of using a PC to reap the benefits of computing. It abstracted away things like file management, installing software, and using a mouse and keyboard.

Cap rates are discussed more than anything in commercial real estate. The beauty of the cap rate is its simplicity—Net Operating Income (NOI) divided by the purchase price. James Graaskamp said that when you buy real estate, you're purchasing a set of assumptions about the future. There are a lot of assumptions embedded in that formula.

Consider a single-tenant property listed for $1,000,000. We're told it generated $100,000 in NOI last year. This suggests a cap rate of 10% ($100,000 / $1,000,000). Simple.

With that data, anyone can calculate the annual dividend of a property or estimate its value quickly without thinking about the fact that:

  • Tenants leave buildings.
  • Properties can be mismanaged or neglected to the point of disrepair.
  • Operating expenses can increase or decrease suddenly.
  • Redevelopment or decline of the surrounding area can influence rent.
  • Technological innovations and societal trends can permanently alter the demand for different property types.
  • Current building designs may become unsightly or obsolete.
  • The lending environment could evaporate, making it difficult for anyone to purchase real estate.

Discussing cap rates is more accessible than unpacking every presumption about a property in casual conversation—like when someone asks, "How're you doing?" and you say, "Pretty good." It's easier than delving into each thing—good or bad—that might have influenced your mood on a given day.

Cap rates abstract away a lot of existential issues facing every property that are important to consider. When evaluating a potential real estate investment, does the advertised cap rate reflect a realistic set of assumptions? It's okay to ask questions. There is no substitute for thorough due diligence.