What Is a Cap Rate, and Does It Matter to an Owner-User?

The cap rate connects a building’s income to its value. The OCC’s handbook for bank examiners defines the capitalization rate as the ratio between a property’s stabilized net operating income (NOI) and its sales price, used to convert income into value. NOI is the property’s annual income after operating expenses, before debt payments and income taxes.

• Cap rate = NOI / price
• Value = NOI / cap rate
• NOI = value x cap rate

Here is a hypothetical, for illustration. A building sells for $2,000,000 and produces NOI of $120,000. Dividing $120,000 by $2,000,000 gives a cap rate of 6 percent. These numbers are chosen for easy arithmetic and do not represent any market.

Think of it as the return a buyer would earn in a year if it paid all cash, before income taxes. Loans are left out on purpose, which allows two buildings to be compared regardless of how each buyer finances them.

Because the cap rate sits in the denominator, a small change produces a large swing in value. Stay with the same hypothetical NOI of $120,000:

• At a 6 percent cap rate, value is $120,000 / 0.06 = $2,000,000.
• At an 8 percent cap rate, value is $120,000 / 0.08 = $1,500,000.

Nothing about the building has changed, yet the value is $500,000 lower. A lower cap rate means a higher price for the same income, and a higher cap rate means a lower price. The OCC handbook notes that interest rate changes may result in changing capitalization rates, thereby affecting a property’s value.

This guide gives no current cap rates because they vary by property, place and time. For a real figure, ask an appraiser or look at the comparable sales behind a specific property.

An investor buys income, so a cap rate speaks directly to its question. As an owner-user, you are buying a place to run your business, which changes the analysis in three ways.

• There may be no real income to capitalize. If you will occupy the whole building, its current rent says little about what it is worth to you. A vacant building has no NOI at all.
• Your repayment comes from the company. The OCC handbook says that for owner-occupied properties, the primary source of repayment is usually the cash flow generated by the occupying business. A lender will usually care more about your debt service coverage than the building’s cap rate.
• Your alternatives are different. The comparison that counts is what it would cost to lease or buy equivalent space, including what moving would cost and what control is worth to you.

So a building with an unattractive cap rate can still be right for an owner-user, and an attractive one can be wrong. A seller’s rent roll may also be irrelevant if the tenants will be gone when you arrive.

Set the number aside as a deciding factor, but do not ignore it. It shows up in these places.

• Your appraisal. The handbook describes the income approach, which converts expected NOI into value through direct capitalization or discounted cash flow, alongside the sales comparison and cost approaches. If the appraised value falls short of your price, your loan may not cover what you expected.
• What the lender asks about the next user. The handbook says underwriting should consider the economic value of the collateral to another user. A rent a stranger would pay, capitalized, is one way to estimate that.
• Related-party rent. If your own holding company leases to your business, the handbook warns that rents used for valuation should be consistent with the market, not inflated by a non-arm’s-length lease.
• Leased space. Income from any tenant you buy into or later add will be analyzed in part this way.
• Resale. Your next buyer may be an investor who prices the building on income, especially if it will be leased to someone else.
• A later sale-leaseback. If you ever sell and lease back, the buyer may price your rent using a cap rate, so the concept can directly affect how much cash you raise.

If a listing or broker quotes a cap rate, treat it as a claim to verify. It is only as reliable as the NOI behind it.

• ✓Is the NOI based on actual results, or on projected or market rents?
• ✓Will the income still exist after we occupy the building?
• ✓Are all operating expenses included, such as management and a replacement reserve?
• ✓Are property taxes shown at current levels, or as they might change after a sale?
• ✓Do the comparable sales involve similar buildings, locations and lease terms?
• ✓If we imagine a tenant in the building at a rent a stranger would pay, what value does that imply?
• ✓How does the price compare with the cost of leasing equivalent space, and with the sales comparison value?

That imagined-tenant test can be useful. Estimate a market rent and operating expenses for your building, compute a hypothetical NOI, and apply a cap rate your appraiser or advisor can support. The result is a cross-check on price, and it also suggests what an investor might pay if you ever needed to sell.

Tenant Advisory Group represents occupiers, so our starting point on a purchase is what the building does for the business and what the leasing alternative would cost. Income measures like this one then test the price. Your appraiser and lender will have the final word on value for loan purposes.