What is Meant by Cap Rate?

Cap Rate

Posted By: Pat Nelson / Jun 29 2017
By Ranah Asad,

One thing that is commonly asked by real estate investors is what all the different commercial terms mean? Such as net operating income (NOI), cash on cash, internal rate of return and cap rate. Knowing these terms and how to calculate them is essential to anyone who invests in real estate. This is especially true for new investors.

If you are learning or if you are a bit unfamiliar with where to start, understanding real estate terminology is the best way to begin. Cap rate is one of the most important concepts to understand. Capitalization rate is used to estimate investor’s potential return on their investments. Knowing the cap rate equation and how it can work to provide for you the best return on your investment will help you make smart investment choices. So let’s get started!

Cap Rate Equation

Cap Rate = Net Income/Value

The cap rate equation looks pretty simple. It begins with the net operation income, which is the annual income the property generates. It boils down to the rent that you are able to charge tenants minus the operating expenses like maintenance and taxes. The value of the property is how much the property is worth in current market conditions. Basically, it is how much you can buy or sell the property for.

Let’s talk numbers. For example a property with a property with an NOI of $10,000 and a cost of $1,000,000 will have a cap rate of 10 percent. Your net operating income controls how much return on your investment you will get. When you are looking to buy investment property, you want to seek out markets and opportunities that offer a high cap rate. Why? Because if you look at an investment property that has a low cap rate, the general net operating income is low in comparison to an investment that offers higher cap rate.

However, buying a property with a high cap rate isn’t the only important thing to look for in real estate properties. A property can be a truly great investment if:

  1. There is potential to unlock additional value in its NOI. This usually means that the property should be able to attract tenants at higher rents than are currently being charged.
  2. The value of the property is well-positioned to benefit from economic recovery. This means that as the economy becomes stronger, buyer demand will increase and drive property prices up.

What is a good cap rate for a buyer of real estate?

Different property cap rates are supposed to represent different levels of risk. A lower cap rate corresponds to a lower level of risk, while a higher cap rate corresponds to a higher level of risk. As an investor, the challenge is to determine the appropriate risk-adjusted return, or in other words, the right cap rate given the the level of risk. When analyzing a potential investment property to determine the right cap rate, there are several core factors one can look at. These include location, asset type, and prevailing interest rates. Let’s examine each to see how they affect cap rates.

1. Location

I’m sure you are familiar with the old saying, “In real estate, location is everything.” This is because the value of any real estate property is directed by demand, and that demand is largely affected by the location. Location can refer to both the Metropolitan Statistical Area (MSA) a property is in, (for example New York or Seattle), and where within that MSA is the property located (the suburbs or urban areas).

2. Asset type

Cap rates also vary greatly within a market, across different asset types. In commercial real estate, not all asset types are created equal when it comes to perceived risk. Multifamily assets consistently have among the lowest cap rates within a market, because they are considered to provide lower risk compared to other asset types. This is true for two main reasons:

  • People always need a place to live, even in an economic downturn. Unlike other business types like fashion stores or gourmet restaurants, which struggle even when times are good.
  • Apartment buildings generate their income from dozens of tenants. If a few of those tenants don’t pay, it doesn’t usually spell disaster for the property’s cash flow because one individual represents a relatively small percentage of the overall income. Compare that to an office building with one large tenant. If they go out of business or relocate their offices, the property may actually lose money until a new tenant can be found.

3. Interest rates

Perhaps the most complex and least intuitive part of understanding cap rates is their relationship with interest rates. Often in real estate cap rates may shift without any change to the actual property or surrounding area but only as a result of a change in interest rates. That is because investing in real estate property is largely driven by the amount of debt that can be borrowed to purchase a property and the resulting spread between the interest rate and the cap rate. The larger the spread, the better the potential return. This makes sense if you think of the interest rate as the cost of money, and the cap rate as the value of money invested into the property.

How to use cap rate to decide on the best investment?

The most important term to understand is Net Operating Income – your final income after deducting all of your expenses. This is where many beginner investors make mistakes, they look at the amount of rent they will receive and subtract their basic expenses and overestimate their income. To avoid this mistake, investors need to keep track of all expenses, both recurring and one-time, in order to calculate their actual return. This includes everything from service calls by plumbers and handymen to even the cost of sending certified letters on important notifications such as lease renewals.