Cap Rates: What You Need To Know

If you have ever thought about investing in real estate, chances are you have heard the term “cap rate” tossed around before. And while there are many familiar terms used in real estate “cap rates” don’t tend to be one of them. When buying a home to live in, we don’t normally consider cap rates. This is only something we tend to start paying attention to when investing in commercial or rental property. A cap rate valuation can be a very handy tool for investors, especially when comparing investments that serve different purposes or have different price points. Using a cap rate analysis, an investor can better compare the opportunity side by side to determine which property will fit their goals more appropriately.

What is a cap rate?

Simply put, the cap rate is used to measure the rate of return that can be expected from an investment. Using a calculated cap rate, you can compare properties and opportunities side by side and assess the risk in more simple terms. The cap rate is a ratio that figures the net yearly operating income of a property in relation to its value. For this ratio, the mortgage on the property is not considered, only the value of the property itself.

Calculating the NOI

The net operating income is comprised of the gross rent collected in a year minus any maintenance, repairs, insurance, management costs, vacancy fund, taxes, and any other direct expenses. If a property will collect 10,000 in rent for the year and cost 3,000 to run (excluding the mortgage), the NOI is 7,000.

Determining Market Value

Some calculations will take the purchase price into consideration, but most sources will say that the market value is the most accurate number to use when assessing a property cap rate. To find the market value of a property, it may be best to speak with a Commercial Real Estate agent in order to identify the actual value in the market at the current time. An experienced Realtor can take into consideration factors that the average (especially novice) investor may not know. For this example, we will use the suggested formula which will consider the market value of the property. Let’s assume the property is worth about 150k in the current market.

Calculate the Cap Rate

The most common way of calculating the cap rate is to divide the net operating income by the current market value of the property. In our example, we will divide the NOI (7,000) by the Market Value (150,000) to arrive at a cap rate of 4.6.

Is a low or high cap rate better?

This is a loaded question that will vary depending on your specific goals and who you ask. There are lots of opinions out there that you will want to weigh out. A lower cap rate will typically mean that a property has less risk associated with the purchase as the price is higher in relation to it’s NOI and the property is likely in higher demand. If selling, this is a desirable trait. If planning to rent, this may not be as ideal as there is less of a gap between running costs and net operating income, meaning a smaller potential for profit in that way. On the other hand, a higher cap rate may indicate more growth opportunity as there is a wider gap between your operating expenses and income in relation to the property value. Properties with higher cap rates tend to be more attractive to investors looking to hold a property for rental purposes. In terms of selling a property with a high cap rate, this is not ideal as the pricing and demand on the property may be lower.

It is important to consider your goals and plans when deciding what and how to invest your money. Speak with knowledgeable professionals who can help guide you into decisions to build your portfolio and financial future.