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Capitalization rates are a key concept in the analysis of commercial real estate. It is defined as the annual net operating income divided by the cost or value of the property. Net operating income excludes external factors such financing and taxes.
Capitalization Rate = annual net operating income / cost (or value)
The cap rate is a useful tool most notably when looking at properties in a similar market. If a property has a significantly higher cap rate this can be an indication of a risk premium. Perhaps the zoning of the property conflicts with its current use; or an environmental issue impacting the property. As part of your due diligence process you need to understand why the cap rate of the subject property is higher than similar properties in the market.
Cap rates can also be looked at from a trend standpoint for a specific market. If cap rates are decreasing this could be a result of perceived risk going down, and the opposite could be true if cap rates are increasing. Further due diligence on the neighborhood should help to establish the reason.
Where to be careful about using cap rates is when the earnings are projected or there are irregular expenses within the Net Operating Income. Therefore, cap rates should be used as a general yard stick and in most circumstances you’ll want to follow up with a (DCF) discounted cash flow analysis before your investment purchase. Take figures provided by sellers with a grain of salt, and ask for support to verify the numbers provided.