What is a Cap Rate, and Why Does it Matter?

What is a Cap Rate?

A Capitalization Rate, or cap rate, is the ratio of Net Operating Income (NOI) to the property asset value. The cap rate helps identify the return an investor can expect investment property. Cap rates fluctuate depending on property class, available product and interest rates as determined by the market. The value of commercial real estate is determined by the return on investment an investor can expect to receive. This differs from residential real estate, which is based on the price per square foot of other nearby comparable properties. It is one of the most popular measures used for evaluating a commercial real estate asset for sale.

How to Calculate Cap Rate

Cap rate can me calculated by dividing the net operating income by the value of the property.Capitalization Rate = Net Operating Income / ValueAs an example, let’s say that there is an apartment building that was recently sold. The building has sold for $20,000,000 and has a Net Operating Income (NOI) of $3,000,000, we can determine the cap rate with the above formula. The property sold at a 15% cap rate.

NOI : 3,000,000 / Value 20,000,000 = 0.15 or 15% Cap Rate

Why is a cap rate used?

Cap rates offer the easiest and fastest way to determine the cash flow potential of a property so that the investor can have a comparison of different investment opportunities.Investors can select different cap rates based on their risk analysis and tolerance. Lower cap rates typically mean that the property is stabilized in a proven market. On the other side of the coin, higher cap rates can mean that the property has issues – such as desirability, maintenance, or vacancy – but may have more potential on the upside.

What is a Good Cap Rate?

This is a great question, but not one that is easy to answer. It depends on how the cap rate is being used. Are you selling or buying a property? If selling, a lower cap rate is better, as it means the property value will be higher. If you’re buying a property, a higher cap rate is better, as it means your initial investment will be lower.Are you trying to find the market-based cap rate, researching recent sales of nearby and comparable properties? In this situation, the preferred cap rate will be one that is derived from similar properties in the same location. A bad cap rate would be one derived from different property types in different markets.

Sources:

Understanding Cap Rate vs. Cash-On-Cash Return in Single-Family Rental InvestmentsWhat You Should Know About Cap RateCapitalization RateHow to Calculate the Cap Rate