What it is
The capitalization rate expresses a property's income as a percentage of its value. It is how buyers, sellers and appraisers translate NOI into price. A lower cap rate means the market pays more for each dollar of income, usually because it sees the income as safer or likely to grow.
How it's calculated
Divide NOI by value. Rearranged, value equals NOI divided by the cap rate.
| NOI | Cap rate | Implied value |
|---|---|---|
| $1,200,000 | 5.50% | $21,818,000 |
| $1,200,000 | 6.00% | $20,000,000 |
| $1,200,000 | 6.50% | $18,462,000 |
The numbers are illustrative. Notice how sensitive value is. A half-point move in the cap rate shifts value by more than $1.5 million on the same income.
Why it matters for a loan
Lenders size loans partly on LTV, and LTV depends on value. If the appraiser picks a cap rate 50 basis points higher than the one in your package, the same LTV produces a smaller loan.
Using the table above, a 65% LTV loan is $13.0 million at a 6.00% cap rate but only about $12.0 million at 6.50%. The sponsor has to bring the difference.
This is one reason lenders also use debt yield, which ignores cap rates entirely. It is also why appraisers support their cap rate with comparable sales, investor surveys and market data.
Going-in and exit cap rates
- Going-in cap rate is in-place NOI divided by purchase price.
- Exit or reversion cap rate is the rate assumed when the property is sold or refinanced at the end of a hold. Lenders on bridge loans care about it because their exit depends on a refinance at stabilized value.
Conservative underwriting usually assumes the exit cap rate is higher than the going-in rate.
Cap rates vary
Cap rates differ by asset class, location, building quality, lease term, tenant credit and the interest rate environment. Stabilized multifamily in a major metro and a single-tenant building in a tertiary market trade at very different rates. Avoid quoting a generic "market cap rate" without support.
Common mistakes
- Applying a cap rate to pro forma NOI and calling it current value. Lenders value what's in place; a pro forma value is a projection.
- Cherry-picking comps. Lenders and appraisers will pull their own.
- Forgetting the exit. On a value-add deal, the refinance math at a higher exit cap rate is the lender's real concern.
In the package
Show the cap rate you used, why, and the comps behind it. A lender that agrees with your valuation logic is far more likely to agree with your loan amount.