Capitalization Rate, also known as the CAP Rate, is the rate of return on a specific real estate investment. This rate is based on the income the property is predicted to generate. Furthermore, when estimating the potential return on investment for the investor, you use the CAP rate.

In order to calculate the capitalization rate, you simply divide the investment’s net operating income by the current market value of the investment.

Often we hear the term Cap Rate when it comes to real estate investments. Let’s learn

about its impact in real estate investments, as well as its benefits for investors in the

current real estate market.

It is the rate of return on a real estate investment property centered on the income that

the property should produce. You can use when you are trying to calculate your

potential returns on your investments.

It is a simple tool, that if you use correctly, can result in valuable information for you as

the investor. The capitalization rate (a.k.a. cap rate) is the ratio between the Net

Operating Income (NOI) or the gross income versus the property assets value. This tool

is used to measure the current value of properties. One benefit of using the real estate

cap rate tool is that it can show the investor’s return on investment (ROI) for one year.

Remembering this easy equation for calculating the real estate cap rate will put you in

front of the market. Let’s say that the NOI was listed at $600,000 and the property

assets value was generated at $100,000:

$600,000 (NOI) / $100,000 (PV) = 6% cap rate

Simply divide the property listing into the NOI to give you the cap rate percentage.

Now let’s say that your NOI was $1,000,000 and the property asset value was $13,000,000. This would equal a cap rate of 7.6%. In other words, this tells you that an

investor would receive 7.6% return on a cash investment.

Taking into consideration, that the NOI is accurate. Any operating expenses will reflect

an inaccurate cap rate.

Moreover, are property taxes current, maintenance fees, utilities, and insurance current on the property? If the property has been financed, annual finance charges need to be subtracted. These operating expenses must be subtracted from the NOI (gross income) before dividing the property assets value. This will give a more definite NOI resulting in an accurate cap rate.

The cap rate tool is beneficial when comparing property market values. The cap rate will determine if you’re at a higher risk with one property versus the other. The real estate cap rate tool is also useful when determining past and present market trends.

Typically, when you compare property investments you may have a problem because

not all investments are the same. Therefore, the cap rate is a good starting point for you

to compare profit percentages.

For example, let’s say you have 2 investment opportunities in front of you. Property A

has a market value of $230,000 and Property B has a market value of $3 Million.

Additionally, estimates that their NOI values will be $40,000 for property A and $300,000

for property B. Moreover, property A’s cap rate is 17.39% and property B’s cap rate is

10%. While the first investments cap rate is much higher, the second one will earn much

more money annually. Thereafter, you can make a more accurate decision as for which

property to choose if you had to go for one or the other.

Essentially, a high cap rate for buyers or investors is a good sign. This means that the

property value is low, so the annual return will be great. On the other hand, having a

high cap rate for sellers means that the asking price for the property is too high.

The cap rate is also a tool that you can use to get a rough idea on the payback period.

You are able to calculate it by dividing 100 by the cap rate when expressed as a whole

number. For example, if your investment has a cap rate of 5%, divide 100 by 5, for an

estimated payback period of 20 years. This method is only recommendable for a rough

estimate of the investments’ payback period because few real estate investments retain

a contact cap rate over a long period of time.

While this is a great tool, it also has its limitation. One of them being that it is not very

useful for short-term investments. Having a little time to produce a trustworthy cash flow,

it can make it almost impossible to get an approximate number in a limited amount of

time.

Although it provides important and useful information when making your decision for an

investment property, it can also misguide you. It is important to use this great tool

keeping some of its drawbacks in mind.

Finally, a point to remember, is that cap rates are most often considered to be cash

transactions and that cap rates differ depending on cities and neighborhoods. If

assessing trends and market values, compare properties that are identical. For

example, same size, same location, and same age. Do not try to use a cap rate tool for

an apartment building with renters versus a single-family home rental. This will give a

false cap rate.