A capitalization rate—commonly referred to as a cap rate—is one of the most fundamental tools in real estate investment. The cap rate represents the ratio between an asset’s net operating income (NOI) and its property value. At its core, a cap rate is a tool that allows real estate investors to determine the risk associated with acquiring or selling an asset.
The cap rate is always the current, accurate market value of the property divided by the NOI. For instance, a property with an asset value of $1 million and a stabilized NOI of $100,000 has a cap rate of 10 percent.
Get familiar with the cap rate
It’s important to understand an asset’s cap rate both before and after purchasing it. The cap rate will tell you how long it will take for you to recoup your investment if you’re considering purchasing a property. For instance, a higher cap rate is desirable when you’re purchasing a new investment property. Alternatively, a lower cap rate means your property valuation is more favourable when you’re selling off an asset.
While calculating and factoring a cap rate into your real estate transaction may seem challenging, it’s essential to your success as an investor. Failure to do your math correctly could lead to a bad transaction that might set your investment business back.
Learning when to use a cap rate—and how to leverage this information—is essential to your success as a real estate investor. While figuring out the cap rate might seem unnecessary after all the other market and economic factors you take into consideration during the lead-up to your real estate transaction, there are insights a cap rate provides that aren’t available elsewhere.
When to use a cap rate
While cap rate information is relevant for all types of real estate transactions, it’s particularly important for investors to acquire or selling off a commercial asset.
For example, if you’re looking to buy a commercial property in a specific area, pay close attention to the cap rate of the property you’re looking at versus the cap rates of other properties nearby. For instance, if your property has a cap rate of 5 percent, while a similarly sized building nearby has a cap rate of 10 percent, there’s a higher rate of risk attached to the property you’re considering.
Cap rates are also helpful for ascertaining real estate trends in a given area. You can look at cap rates over time and use this information to calculate trends for a given sub-market. It’s a great way to make informed predictions about where the local sub-market is heading next.
Using this information, you should be able to predict with some level of certainty where real estate valuations will go in the coming years. This is particularly helpful if you plan to acquire, rehabilitate and sell your commercial investment property.
Cap rates aren’t an end-all solution for real estate investors hoping to acquire or sell-off a property. There are some instances when you’ll need to make a more complex type of calculation to determine the risk associated with a specific investment.
For instance, if the property in question has a relatively irregular cash flow that makes it challenging to determine the NOI, you’ll have to perform a discounted cash flow (DCF) analysis. This type of analysis is more complex and involved than determining the cap rate, but will still provide you with an accurate picture of risk and projected valuation.
Calculating your NOI
You need one essential number to determine your cap rate. You’ll first have to determine what your NOI is.
To determine your NOI, it’s helpful to look at your property’s cash flow on a monthly level. First, you have to determine how much income your asset is bringing in, and then subtract all your operational expenses.
For example, say you earn $1,000 a month in rental income from your property. You then pay $100 a month in property management fees, $50 a month in insurance premiums, $50 a month in utilities and another $100 a month in utilities. This brings your total monthly expenses to a total of $300. Subtracting this from your rental income leaves you with a monthly NOI of $700, or an annual NOI of $8,400.
The NOI of $8,400 is the number you’ll divide the value of your property by determining the cap rate.
It’s often helpful to factor in potential vacancies or unexpected expenses into your NOI calculation. This will provide you with a more accurate view of your property’s true cash flow.
Determining a good cap rate
Whether a cap rate is desirable or not depends on whether you’re buying or selling the asset in question. Generally, buyers will want to find an asset with a cap rate of 10 percent or higher. In markets with higher operating expenses, a cap rate between 8 percent and 9 percent is also often seen as desirable.
If you’re selling a property, it’s usually better to have a lower cap rate. This means your property’s valuation is higher. It’s important to understand, the lower your cap rate is, the less attractive the property will be to a potential buyer.
As with all metrics you use to inform your real estate investment decisions, cap rates should never be looked at in a vacuum. Cap rates provide investors with good information. They’re not, however, the end of the conversation. If the other fundamentals of an investment look promising, consider balancing out cap rate information with other metrics.
Cap rates offer good insight
To learn more about cap rates in your market, connect with your local community of real estate investors. They can provide you with historical insight into cap rates in your area, and help you determine how to factor cap rates into your decision making when acquiring and selling off properties.
The more you learn about cap rate and get comfortable with using it, the more away of value you’ll become. It’s a good quality to have as an investor—especially a commercial real estate investor.