Capitalization rates, or cap rates as they are typically referred to, are one of the most frequently used measures when assessing the value of real estate investments. They are used to estimate an investor’s potential return on a property and are expressed as a percentage. The formula for calculating a cap rate is simple:
Cap rate = net operating income (NOI) / property sale price or current market value
For example, a property being sold for $1,000,000 with a net operating income of $100,000 would have a 10% cap rate ($100,000/$1,000,000).
Cap rates can fluctuate based on changes to property NOI or value. NOI is based on the annual amount of revenue the property is expected to produce less any operating expenses, such as maintenance, utilities, insurance or property taxes. Cap rates assume that a property was purchased for cash without financing, so debt payments aren’t a variable in this calculation. So, one way to think about a cap rate is the percentage return an investor could potentially receive if the property was purchased on an all-cash basis.
How are cap rates used?
- For comparison - Cap rates are often used to compare investment opportunities. They can be applied at the individual property level or more broadly across a market or property sector. They help create a general “apples-to-apples” comparison for investors, real estate brokers and others seeking a baseline comparison and potential value for an investment. As an example, let’s say Property A was being sold for $1,250,000 with a NOI of $70,000, making its cap rate 5.6%. Property B also has a sales price of $1,000,000 with a NOI of $70,000, equaling a cap rate of 7%. Everything else being equal, the 7% cap rate most likely represents a better opportunity for the investor. Keep in mind, that cap rates work inversely, meaning when the value goes up the cap rate goes down and vice versa.
- As a measure of risk - Cap rates may also be used as a measure of potential risk – those properties with low cap rates may be regarded as having less risk than those with higher cap rates. Properties in central business districts (CBDs) in major metropolitan areas generally have lower cap rates than properties in rural, small towns; CBDs tend to have infrastructure, amenities, and a workforce to support the higher property value. While there may be a lower rate of return, a lower cap investment could be seen as less risky because of strong economic activity within that market. For example, if a property were to become vacant, it could be easier to lease to another tenant in the CBD verses a rural area given typical market demand.
- In conjunction with other factors - While cap rates are a quick and easy way to compare and contrast properties based on rates of return and risk, there are also many other factors to consider when fully assessing an investment property. Age of the property, lease term remaining, location, creditworthiness of tenants, type of lease, building condition, etc., should all be considered in order to paint a full picture of what the investment is truly worth.
What makes a cap rate good?
Well, it depends. It’s up to the investor to take note of all factors surrounding the purchase and make a decision. Cap rates may indicate to the investor if a property is overpriced, at par or a bargain compared to others. It can also help evaluate the attractiveness of the location based on market demand in the area and how potentially risky an investment may be.
As you venture into the world of real estate investing, cap rates are going to be one of the most commonly used tools to help evaluate an investment. But as with all investment opportunities, one number won’t tell you everything; it is typically best to do your own research to help better understand the story the numbers are telling you about the property.
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