What is Cap Rate?
Cap rate is the abbreviation for capitalization rate. It is the ratio of net operating income (NOI) to the value of the property. As an example, if you bought a property with an NOI of $500,000 for $5,000,000, the capitalization rate or cap rate would be 10%. It is calculated by taking the NOI and dividing it by the purchase price ($500,000/$500,000,000 = 10%).
Why is a Cap Rate Important?
Cap rates are often used by buyers and sellers of commercial real estate and on real estate investment properties.
Cap rates can fluctuate a great deal based on the type of property, location of
the property as well as the condition of the property. It could be said that it is a measure of the supply and demand of particular types of real estate properties in various areas. Multi-family, single family, medical properties, retail properties, or office or any type of income producing real estate can be measured by the prevailing cap rates in the area.
Let’s compare a multi-family property in Dallas, Texas with a comparable multi-family property in Bismarck, North Dakota. In Dallas, demand for rental properties is high so the property might have a cap rate of 5%. In Bismarck, demand is not as high and so that property might have a cap rate of 6%. Even though the income might be the same for both properties, (the NOI is $250,000 for each property), you would pay more for the property in Dallas than in Bismarck ($250,000/.05 = $5,000,000 in Dallas versus $250,000/.06 = $4,166,667,000 in Bismarck).
Cap rates are not the only way to measure what you would pay for the
purchase of a real estate investment. However they are an important valuation model when comparing one property to another. They can also illustrate a trend for the area in which you are buying. Other factors one should consider when buying a real estate investment are as follows:
- Repairs needed
- Age of property
- Financing options
- Tenant mix
- Credit worthiness of tenants
- Length of leases
- Supply and demand for property type in local area
- Demographics of the region including population growth, employment and property inventory
Cap Rate Calculator
Use of your simple calculator on your mobile device can calculate the capitalization rate or cap rate. However, if you wanted to use a cap rate calculator, you can google “cap rate calculator” and numerous options become available for your use.
Cap Rate Summary
Cap rate is an indirect measurement of how fast an investment will pay for itself. It is also a useful tool to get an indication of how much you should pay for or sell a particular property. Keep in mind the caveat of the need for additional due diligence. Other factors must be considered in a buying or selling decision as it relates to investment real estate.