Understanding Cap Rates

Today’s Thesis Driven is a guest letter from Simon Jawitz. In addition to a multi-decade career spanning law, investment banking and teaching, Simon was most recently CFO of Common Living and a member of the board of directors of Bank Leumi USA.

Capitalization rates (“Cap Rates”) are ubiquitous in the world of real estate. Rarely, if ever, will you receive marketing materials from an investment sales broker that do not reference an “attractive cap rate.” 

 If you corral a group of real estate professionals in a room, you will likely get no disagreement on the definition of a Cap Rate. However, you may very well find disparate views on the information it conveys, its proper use, and whether it is a crucial element in determining the value of income producing real estate.  Like price/earnings (“P/E”) ratios in corporate finance, cap rates serve a real purpose but are often misunderstood and misused. 

In this letter, we will:

1. Review the definition of a Cap Rate; 
2. Explore the basic math underlying the concept; 
3. Discuss the similarities to P/E ratios and what those similarities teach us; 
4. Examine the uses and misuses of Cap Rates; and 
5. Conclude with a discussion of how Cap Rates fit into the real estate finance toolbox.