Going-in cap rate or capitalization rate, or initial yield, as is often referred to, is calculated as the ratio of the projected net operating income (NOI) in the first year of the holding period over the acquisition price of the property. This measure also represents the investor’s income return in the first year, but also in subsequent years, if NOI does not change.
Some authors and analysts when referring to the cap rate calculation refer to the use of a stabilized NOI and some to the use of the NOI of the first year of the holding period (see our post on the cap rate formula for more on this). There may be a discrepancy between the two if the property has a high vacancy rate at the time of acquisition. Stabilized NOI refers mainly to the income that the property can produce at a long-term average occupancy in the market within which it competes for tenants. This may range from 90% to 95% depending on property type and location. However, a 95% occupancy is more often used for the calculation of stabilized NOI.
An investor considering an acquisition of an income-producing property can calculate the going-in cap rate implied by the seller’s asking price as a quick way of evaluating the reasonableness of the asking price. For example, an asking price of $10 million for an office property with projected first-year NOI of $300,000, which implies a going-in cap rate of 3% is unreasonably high. Based on NCREIF (National Council of Real Estate Investment Fiduciaries) data in the US, going-in cap rates for commercial property rarely fall below 6%, especially in the case of office property, so a 3% going-in cap rate would signal a very high price. In such a case, the investor needs to investigate whether the rents charged to current tenants are considerably below their market level and try to understand as better as possible if there are any special circumstances in terms of income or value increase potential that would justify such a low going-in cap rate.
The major question that a smart investor should answer when considering a particular property investment opportunity is the maximum price that he can pay in order to achieve his/her minimum target return, taking into account the risks associated with specific property and location. This maximum price should be calculated using the discounted cash flow model. This model takes into account all acquisition costs and all expenses (including loan repayments) and revenues during the holding period, as well as the resale price and the remaining balance of any mortgage loan associated with the property at the end of the holding period.
In cases that the investor is interested mostly in securing a minimum income return, with little concern about capital gains from future increases in the value of the property, then the minimum acquisition price may be determined by using that required minimum income return as the going-in capitalization rate. Of course, it is important to understand that independently of the investor’s required return, a typical property transaction of an income-producing property (where no special circumstances are present that will force the seller to sell below market price) will take place only at a price that will reflect a going-in capitalization rate that is in line with market prevailing cap rates for the particular property type in the local market. See our post How to Calculate a Market Cap Rate for an elaborate discussion of how to estimate market cap rates.