A capitalization rate is a very common and useful ratio in commercial real estate, and while it can be helpful in many scenarios, it is often misunderstood and used incorrectly. By definition, the ‘cap rate’ is the ratio of net operating income (NOI) to property asset value. It represents the percentage return an investor would receive on an all cash purchase. It can, and often is, used to quickly size up an acquisition relative to other potential investment properties. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property should immediately indicate that one property has a higher risk than the other.Cap rates can also be helpful when they form a trend. Looking at historical cap rate data can quickly give insight into the direction of values. For instance, if cap rates are compressing that generally means values are going up and conversely, if cap rates are increasing, values are going down. While cap rates are useful for quick calculations, there are times when cap rates should not be used. When properly applied to a stabilized net operating income (NOI) projection, a cap rate can produce a valuation generally equal to what could be generated using a discounted cash flow (DCF) analysis. But, if the property’s net operating income stream has substantial variations in cash flow, only a DCF analysis will provide a credible and reliable valuation.One way to think about the cap rate is that it’s a function of the risk free rate of return plus some risk premium. In finance, the risk free rate is the theoretical rate of return of an investment with no risk of financial loss. Now admittedly, in practice all investments carry even a small amount of risk but because US bonds are considered to be very safe, the interest rate on a US treasury bond is normally used as the risk-free or ‘safe’ rate. So what does this have to do with cap rates? Suppose a client has $1,000,000 to invest and 10-year treasury bonds are yielding 3% annually. In theory, this means the client could invest all of the money into treasuries, considered a very safe investment, and just sit back, put his feet up, and just collect checks. But what if the client had an opportunity to sell the treasuries and invest in a Class A office building? Well, a quick way to evaluate this potential investment property relative to the safe treasury investment is to compare the cap rate to the yield on the treasury bonds. And here’s how. If the acquisition cap rate on the investment property was 5%, this means that he risk premium over the risk free rate is 2%. This 2% risk premium reflects all of the additional risk the investor would assume over and above the risk free treasuries, which takes into account factors such as age/condition of the property, credit worthiness and diversity of the tenants, length of the leases, supply and demand fundamentals for the asset class and economic fundamentals such as population and employment growth, and inventory of comparable space on the market.When all of these items are taken into account, it’s easy to see their relationship to the risk free rate and the overall cap rate. It’s important to note, however, that the actual percentages of each risk factor of a cap rate and ultimately the cap rate itself are subjective and depend on business judgement, experience and tolerance for risk.A cap rate can also be calculated by developing the band of investment method. This approach takes into account the return to both the lender and the equity investment in a deal. The band of investment formula is simply a weighted average of the return on debt and the required return on equity. For example, suppose an investor can secure a loan at an 75% loan to value (LTV), amortized over 20 years at 4%. This results in a mortgage constant of 0.07272. Now suppose that the required return on equity is 8%. This would result in a weighted average cap rate calculation of 7.5% (rounded) - mathematically derived as 75% of the mortgage constant plus 25% of the equity.In conclusion, while the cap rate can communicate a lot about a property quickly, it can also leave out many important factors in a valuation, most notably the impact of irregular cash flows. The solution is to create a multi-period cash flow projection that takes into account these changes in cash flow, and ultimately a DCF will arrive at a more accurate valuation. Linda Dietrick, CCIM is the managing partner and director of the appraisal department at Dietrick Group, LLC.