What is Capitalization Rate?

What does cap rate mean and how can it be calculated? This popular metric can help real estate investors make informed decisions about possible investments. It can help gauge whether or not an investment will be sound and profitable. But how do you know what cap rate on an investment will be? Here, we’re covering two methods for calculating capitalization rates and offering some simple examples to consider.

How is Cap Rate Used?

What is a cap rate in real estate and how is it used? Real estate capitalization rate is a metric used by buyers, sellers and brokers. 

Buyers use cap rate as an indicator of what type of deal they can achieve on a property. They compare cap rate to other sales prices on similar properties.

Brokers and sellers use capitalization rates as a way to set listing prices on a property. Cap rates can be vehicles to attract prospective buyers to the assets they represent.

Calculating Cap Rate

There are two primary methods for calculating capitalization rates commercial real estate investments might achieve. Each is based on the asset’s “net operating income,” or NOI, which is the expected yearly income of the asset, minus the total of expenses incurred from asset management.

The most popular method of computing cap rate involves dividing the NOI by the asset’s current market value. For instance, let’s say a rental property is valued at $1m and is expected to generate $100,000 annually. You also must factor in management, maintenance and taxes - let’s say those will cost around $20,000. Then, the NOI for the asset is $100,000 - $20,000 = $80,000.

So, in this example, the cap rate = NIO ($80,000) / Current Value ($1m)
80,000/1,000,000 = 8 percent

Another method for calculating cap rate involves dividing the NOI by the purchase price of the asset. However,  savvy investors understand that this method can yield unrealistic results for aged assets (those that were sold years ago at prices significantly less than current market values). Additionally, this method also can’t be used for inherited properties. This is because the purchase price on an inheritance would essentially be $0, which is impossible to divide by.

What is a Good Cap Rate

What does cap rate mean in real estate, and what is considered a “good” rate? Unfortunately, the answer isn’t quite as concrete as we may like. Each real estate transaction is unique due to various factors that affect the NOI. These include interest, taxation and amortization (just to name a few). Of course, changes in NOI could drastically affect an accurate computation of capitalization rates.

So, in one market, investors may not be willing to acquire an asset with a cap rate of less than 10 percent. In other markets, a 6 percent cap rate may be considered excellent. Many experts agree that any capitalization rate between 4 and 5 percent is optimal because it allows for a consistent stream of revenue without unnecessary risks.

Again, every real estate transaction is unique based on various factors. There is no Golden Rule about the "best" capitalization rate to look for.

Examples of Capitalization Rate

What is a real estate cap rate? Let’s look at a couple simple examples. Assume an investor has $2m to allocate between one of two prospective opportunities.

Opportunity 1 involves investing the entire $2m in zero-risk government treasury bonds that yield a consistent, guaranteed 3 percent return. This investment would be stress-free, and the investor could just sit back and collect an appreciable profit.

Opportunity 2 involves investing $2m on a commercial real estate property with established tenants. Let’s assume that the property brings in $180,000 from rent payments and that maintenance, management and taxes cost $40,000 annually.

The NOI is $180,000 minus $40,000 = $140,000.

The capitalization rate is NOI ($140,000) / Current Value ($2,000,000) = 7 percent

So, the investor can decide on opportunity 1’s guaranteed 3 percent, or opportunity 2’s slightly risky 7 percent. Sure, there are risks of renters not paying in option 2, but the extra 4 percent ROI might justify the risk-taking. When evaluating return on investments, investors also need to be mindful of inflation. Will that 3 percent be able to stand up against expected inflation in coming years?

Of course, the final decision will depend on the personal traits and risk tolerance of any given investor. Think about how much capital there is to work with, and how much you can afford to gamble. A safe and guaranteed 3 percent is enticing, but so is achieving a profit of 7 percent after assuming a relatively safe risk.

Final Thoughts

What is cap rate in real estate? At a very high level, it’s just a metric that can help investors benchmark the profit potential of a given asset. Cap rate real estate values can also help sellers entice buyers. Capitalization rates are fairly simple to calculate and provide a fast method for making general determinations. They’re important for real estate professionals and investors to understand, but shouldn’t be the only metric used to make purchasing decisions. At the end of the day, investors can benchmark profit potential using cap rates - and that’s important to understand if you’re thinking about delving into the world of real estate investments. 

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