"Cap Rate"-based Valuation

A market's Capitalization Rate or "Cap Rate" is one of the primary factors determining a property's value. Simply put, a Cap Rate is the rate of return an investor demands on invested capital.

If a market is described as a "10-cap", it means a buyer expects to receive (on a debt-free property) a 10% cash return (estimated to be approximately 3% to 5% of gross revenue a year). For instance, a property generating $1,000,000 per year in Net Operating Profits would be worth $10,000,000 in a 10-cap market. If Cap Rates were to shift to a 7.5-cap market, the same property would be worth more than $13,000,000.



For the past 20 years, we have witnessed a steady decline in interest rates. Because the real-estate market south-of-the-border was still experiencing some difficulties in untangling itself from one of the largest banking collapses in history (the Savings & Loan crisis of the late 1980s/early 1990s), the Cap Rate peaked about two decades ago.



Since 1992, the Cap Rate has only fallen approximately 25% while long-term interest rates declined during this period by more than 50-60%. (See Interest Rate vs. Cap Rate chart.) As Cap Rates fall, the value for real estate rises since investors are prepared to accept a lower rate of return on their invested capital. The same $1,000,000 of profit produces a substantially different equity value depending on the market Cap Rate.