What is a Cap Rate in Real Estate

What is Cap Rate?

When investing in income-producing commercial property, analyzing the rate of return is a key step. More than that, comparing the rate of return to other potential investments will help you make the most lucrative decision based on the opportunities available. While there are several important factors to consider as you complete your property analyses, the cap rate should receive ample attention.

What Is the Cap Rate?

The cap rate, or capitalization rate, is used to determine the per-dollar return on an investment property. Because computing the cap rate is a quick and easy step, it is often used by savvy investors to initially identify opportunities that deserve further consideration. A quick online search may reveal the average cap rate for different types of commercial real estate in a specific area. When you know the cap rate for a specific property, you can easily compare it to the average cap rate in the area and to other specific properties listed for sale.

How Is the Cap Rate Calculated?

The capitalization rate is calculated by dividing a property’s net income by its value. It is read as a percentage, so you will need to finish the calculation by multiplying the result by 100. For example, assume the net operating income for a property per year is $100,000, and the value is $1 million. The calculation will be $100,000 x $1,000,000 x 100. The result is a 10% cap rate.

What Impacts the Cap Rate?

The cap rate can be completed as a back-of-the-envelope calculation, but a more detailed analysis will reveal more information for the investors. The quality of the numbers used for the annual net income and the property value directly play into the accuracy of the cap rate. Many commercial real estate listings include the cap rate. However, you may not know what numbers were used to calculate the listed cap rate. With this in mind, it makes sense to dig a little deeper to complete your own analysis. For example, the annual net income should take into account current property taxes, insurance, repair costs, management fees, utilities, and other recurring expenses. It does not include the mortgage payment, however. If a previous owner has been running a property poorly, he or she may have low repair costs per unit. Perhaps the property has been self-managed, so the NOI does not take into account a management fee. These are only some of the factors to consider as you determine the real cap rate for a property.

Keep in mind that the published cap rate for some properties will include realistic figures for these expenses. Other published cap rates will not. This can make it challenging to do an accurate, comparable cap rate analysis. Investors should consider obtaining and reviewing the most recent year's operating statements for all properties that are of interest.

How Is the Cap Rate Used?

The most obvious use of a cap rate is to analyze a property’s rate of return, but it can also be used to compare the investment risk of different properties. A high cap rate indicates that a property has a low sales price in relation to the income that it is producing. A closer look at why the sales price is low could reveal risk. While a higher cap rate may be enticing, that property may not be suitable for an investor who cannot tolerate a high level of risk. Remember, however, that the average cap rate will vary by location and property type. It will also vary by the quality and condition of the asset.

In some cases, an investor may purchase a property with a lower-than-average cap rate if he or she believes that rents can increase in the near future. For example, a new college campus may be built in the area soon, or a major employer may be opening a facility. These are some of the factors that can increase demand and drive rental rates for certain property types higher. However, because this investment in a low-cap-rate property is based on projections, it may also be considered to be risky.

How Do You Analyze the Cap Rate?

After you compute the cap rate for a property, you understandably want to know if that rate is good or bad. A cap rate is a varying figure. In a hot real estate market, for example, property values may increase sharply in a short period of time. Perhaps rents will increase rather rapidly as well, or specific property expenses will shoot up. When you compare cap rates for investment opportunities in a specific area, it is important to understand what market conditions are and how they are expected to change in the near future. A cap rate should be considered as a snapshot of return on investment for a specific period of time.

With this in mind, a cap rate using an accurate, current NOI can tell you more about a property’s rate of return and its risk. If you have access to the cap rate of a specific period of time over the last few years, you may also be able to determine how well the property has performed through changing market conditions.

What Are Other Factors to Consider?

A cap rate only takes into account two data points, the net operating income, and the property value. Other factors must be considered in order to make a thorough comparison. For example, you need to consider the future cash flow of the property, the time value of money, the cost of debt, and more. Some of the other calculations used to thoroughly analyze and compare investment properties are the gross rent multiplier, the internal rate of return, and more. Savvy investors will analyze all of these factors.

You can see that it is important to complete a cap rate analysis on each property that you are interested in and to ensure that the cap rate is as accurate as possible based on the data available. Understanding what the cap rate means is equally essential. When you analyze the cap rate in comparison with other analytics, you can more confidently make an investment decision that is aligned with your risk tolerance and your investment objectives.

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