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Writer's pictureCory Mortensen

Capitalization Rate | Cap Rate

Updated: Feb 21, 2023

Cap Rate: a percentage rate of return on a property based on its net operating income

 

WHAT IS A CAP RATE?


A Capitalization Rate (Cap Rate) refers to the rate of return that is expected to be generated by a real estate investment property. It is used to forecast an investor's potential return on their investment in the real estate market.




HOW ARE CAP RATES CALCULATED?


Cap Rates are calculated by dividing the net operating income by the current market value of the property.



Net Operating Income: The annual income left over after subtracting all operating expenses.


Current Market Value of the Asset: The sales price of the asset.



HOW ARE CAP RATES USED WHEN EVALUATING REAL ESTATE INVESTMENTS?


Let's look at a quick example:


Assume that you are an investor looking to place your hard-earned capital in real estate. You've identified three potential properties and have their trailing 12 months of income and operating expenses. Likewise, your broker gives you the market values of the subject properties. You remember the value of Cap Rates and decide to calculate this metric to evaluate your various opportunities:




After completing your Cap Rate analysis, you determine that Property B has the highest cap rate of 8.3%.


Although the Cap Rate gives us a good picture of performance, Cap Rates are also viewed as a measure of risk. A higher cap rate indicates the investment holds a high risk. Likewise, a lower cap rate means the investment holds less risk. Thus, determining whether a high cap rate is better will depend on the individual investor and their risk profile.


LIMITATIONS OF THE CAP RATE


The cap rate is the most common metric through which commercial real estate investments are analyzed in terms of their yield and profitability. However, when used alone, cap rates are insufficient because they assume you bought the property with cash and it does not consider debt service, the time value of money, or post-renovation cash flows, among other factors. Therefore, it should be used alongside other relevant metrics such as the Cash on Cash Return (CoC), Equity Multiplier (EM), Internal Rate of Return (IRR), etc.


TAKEAWAYS

  • The Cap Rate is a return or profitability metric utilized to assess the return on investment of a real estate property.

  • To calculate the Cap Rate, divide the property's net operating income by the current market value.

  • The Cap Rate should be used alongside other metrics when analyzing investment opportunities.

  • Cap Rates are most valuable when comparing the relative value of similar real estate investments.


 

Thank you for reading! If you have any questions or would like to learn more about investing in real estate, our team at One-9 Holdings would love to connect.












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