Cap Rates Explained

Evaluating potential real estate investments involves using several key metrics and formulas, and one essential formula to consider is the cap rate for a property. Cap rates, also known as capitalization rates, are used to determine the potential rate of return for an asset. While they are predictive in nature and can have variable results, cap rates can provide a good look at the risk versus reward for a real estate investment. Let’s take a closer look at cap rates, how they are determined, and how they can be used.

Determining Cap Rates

There are several formulas you can use to determine the cap rate for a property or group of properties. The most common method is to divide the property’s net operating income by its current market value. This means calculating the asset’s income after taking all maintenance, capital investments, and other expenses into account to determine the NOI before applying the cap rate formula. However, you can also substitute the purchase price of the property for the current market value to formulate the cap rate of an asset you are looking to buy. Both formulas provide a look at a property’s potential performance, though the purchase price of a property can be variable depending on the fluctuations of the market and other contributing factors.

Variables That Impact Cap Rates

It’s important to take a closer look at some of the variables that can impact capitalization rates, as they may increase or decrease the risk associated with real estate investments. One key variable is the occupancy rate of a rental property. An asset with a 70% occupancy rate may have lower risk than one with 40%, but you’ll also need to remember that occupancy rates can change over time. Other variables include:

  • The need for capital expenditures/major renovations
  • Rises in interest rates
  • Fluctuations in real estate market values
  • Liquidity

Cap rates are predictive of a property’s potential success, and keeping these variables in mind can help you better determine the changes in risk associated with your investment.

Good Cap Rates Versus Bad Cap Rates

It can be tempting to look for a simple answer to understand cap rates; what is a good rate and what is a bad one? However, cap rates mean different things to different investors. An asset with a low cap rate can be looked at as more stable with less risk, while higher cap rates may be associated with higher risk. The rate that works best for you as an individual investor corresponds with the amount of risk you’re willing to take on. With higher risk can come higher rewards, so you’ll want to take your tolerance into account when reviewing cap rates for properties you might be interested in investing in. Choosing a REIT instead of purchasing a property all on your own can help mitigate the risk while allowing you to invest in those assets that might yield a higher rate of return.

How to Use the Cap Rate

You can use the cap rate for a property in several different ways. You may use it as a comparison to other similar properties to determine the best potential rate of return and lowest risk factors, but cap rates also yield other benefits for investors. For example, investors looking for lower-risk options for diversifying their portfolios might compare the rate of return for CDs and treasury bonds to the cap rate for a REIT. If the CD or bond offers a 3% rate of return but the cap rate for a REIT comes in at 4-5%, the risk versus reward for the real estate investment might be the better option. Of course, it’s always best to check in with your financial advisor to assess your risk factors and comfort level as you plan to add to your portfolio. 
Cap rates are just one tool investors can use when making decisions about their portfolios. To learn more about some of the other formulas, or to learn more about how DiversyFund can play a role in your wealth-building future, check out our other educational posts here.

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