What Is a Cap Rate?

The term cap rate is short for capitalization rate. Simply defined it is the income divided by the sale price. For a given income on a property, a higher sale price equates to a lower cap rate.

Think of a cap rate as similar to an interest rate on a savings account at your local bank. If you want to earn a return of 5 cents, and the interest rate is 5%, then you need to invest a dollar for one year. If, however, you invest at a rate of 3%, and you still want to earn 5 cents, the amount you need to invest increases.

cap rate = Income
               Sale Price

A similar concept is yield. Specific definitions for yields and cap rates include specifications on what types of income, expense, and sale components are included.

The cap rate's multiplier effect on operating income means that a small change in cap rate has a large impact on pricing. Understanding what can move cap rates is important for anyone involved in real estate including organizations renting space.

Renters need to be aware of property sale pricing as it affects rents.

Owners who have paid high prices for a property expect to get good returns, and that means they expect higher rents. As the value of their property declines, they may be unwilling to give up on their hopes for a positive return and therefore push for higher than market rents. The smart tenant understands how far they can go in pushing for reductions in occupancy costs before they push the owner into failure. They should also understand what happens in a foreclosure process and the ramifications of a sale of the property.

If we accept that the primary influence on cap rate to Treasury spreads is transaction volume, then we can keep an eye on that volume to predict short-term pressure on cap rates. But how can we predict Treasuries? PIMCO, the noted authority on such things has a long track record of positioning their clients well with fixed income investments including all sorts of bonds. Bonds yields and pricing are highly complex and often counter-intuitive. As the general economy improves, or is expected to improve, most of us understand that the stock market goes up. Bonds however, move to a different rhythm. Bond pricing is largely driven by the market's expectation for inflation. Those of us with some gray at the temples well remember the high inflation rates of the late 1980's with 15% mortgages and CDs of 10%. In the late 80's, people expected the dollar's purchasing power to decline. It is the expectations of bond purchasers that sets bond pricing.



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