A Guide to Understanding Capitalization Rates
If you’re trying to decide whether a certain property is a good investment, one useful statistic to understand is the capitalization or “cap” rate. The cap rate tool is used often in the real estate industry, but calculating it accurately can be a complex process. Gaining a clear understanding of how the cap rate can be used to evaluate risk when purchasing a property can help you make sound investment choices.
Capitalization Rate Definition
The cap rate is a ratio that represents the percentage return a property investor would receive in one year. It is calculated by dividing the annual net operating income of a property by the property asset value. For example, suppose a building valued at $500,000 had an annual net operating income of $50,000. The cap rate would be $50,000/$500,000, or 10 percent. Intuitively, the cap rate tells you what percentage of your investment you can expect to earn back in a year. Although this is a bit of an oversimplification that would only be completely accurate for an all-cash investment, it’s a useful starting point for evaluating whether a property will be a good investment.
When to Use the Cap Rate
The cap rate can be very helpful in several circumstances. For example, a rough cap rate calculation can help you to assess the value of a purchase compared to other potential investment opportunities. Suppose you’re considering two similar properties in a similar location. One has a cap rate of 6 percent, while another property has a cap rate of 17 percent. A comparison of the two cap rates immediately tells you that the second property would potentially offer a better return on your investment.
Cap rate calculations may also form a trend that can help investors to understand market fluctuations. For example, if cap rates in an area are decreasing, then that means that market forces are driving prices up. Understanding historical cap rate data can yield insight into the potential long-term performance of an investment.
When Not to Use the Cap Rate
As stated before, the cap rate is a bit of an oversimplification that makes the most sense when used for a property with a stable net operating income that has been purchased completely with cash. However, if a property has a fluctuating income stream, or if the owner owes debt on the property via a mortgage or other loans, then a cap rate calculation becomes less credible as a true valuation of the property.
Components of the Cap Rate
The calculation of the cap rate should take into account the value of the additional risk you assume when you purchase an investment property. Risk is made up of any factors that can cause your investment to lose value, and in real estate these factors include things like:
- The property’s age
- The tenants’ credit worthiness, the number of leases in place, and the length of these leases
- Population growth, employment growth, and the value of comparable properties in the area
All of these elements of risk will impact cash flow, and they are therefore pertinent to consider and must be factored into the calculation of the cap rate.
Calculating the most accurate picture of the value of a property is a complex, multi-layered process that needs to account for the future value of cash, the weight of capital expenses, and the impact of irregular cash flows. Although a cap rate doesn't take these elements into account, it does offer a simple way for you to quickly learn a lot about a property and make a purchasing decision.
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