The cap rate in real estate (or ‘capitalization rate’) is a core concept when it comes to commercial real estate. But despite this, the term itself is misunderstood by many, and sometimes used incorrectly altogether.
The following article aims to explain what the cap rate is, and give a better understanding of its relevance and true meaning.
What is Cap Rate?
The cap rate – or capitalization rate – refers to the ratio of NOI (Net Operating Income) in relation to the value of a property. For example, if a certain property were to cost you $300,000 but also had an NOI of $30,000, then the capitalization rate of this property would be 10%, as $30,000 is 10% of $300,000. This term is also called ‘rate of return’ or ‘yield’ in other countries and regions.
What’s Considered to Be a Good Cap Rate?
There’s no set number of values that show what is a good cap rate. This is completely depending on the investor in question, as well as their goals and financial situation.
If you’re selling a property, then having a lower cap rate is beneficial, as this will give your property a higher value when on the sale market. But if you’re buying a property, having a lower cap rate will be more beneficial, as this will often result in a lower price for the property, meaning that your initial investment amount will be lower too.
But even this can add some confusion – as a ‘low’ or ‘high’ cap rate is completely dependent on properties within your region. The best way to work out if the cap rate of a potential property is high or low, is to put it in direct comparison with similar properties in the same or similar areas. Comparing properties in different markets or locations adds confusion, and can often lead to miscalculation.
When Should You Use Cap Rate?
There’s a reason the cap rate is currently a very common ratio to use. Experienced real estate investors know that it’s a valuable tool in determining whether a potential investment is worthwhile or not.
Not only is it good for determining whether a particular property is worth purchasing, but when lots of properties are on the market, it’s great too for working out whether one property is better than another. If two similar properties are on the market, and one has a 12% cap rate vs. an 8% cap rate, this makes choosing the right property a lot easier.
But changes in cap rates over recent years also help create projections on where the market is going to go moving forward. By analyzing changes in cap rates, you’ll have a much better insight as to whether property values will go up or down.
Cap Rate Components
There are various components of a property’s cap rate, some of which are more obvious and easy-to-spot signs than others. Many people think of the cap rate as a measure of ‘risk-free return’ – in short, how much money an investment can return to you without the risk of any financial loss.
It goes without saying that any investment has an element of risk. But when it comes to the regulations around properties and property-ownership, these risks are much lower in the long run, and are therefore considered by many to be ‘risk-free’.
Many people look at it like this. If you have $500,000 that you could put away in something like a 10-year bond or savings account, this is a safe way of investing money, as you’re guaranteed that 5% return, whilst also guaranteed not to lose your money due to legal protections involved in these bonds. So, if a property’s cap rate was 10%, although this is double what your bond or savers account would offer, this increase also brings an element of risk with it. So, it’s up to you to determine whether an increase of 5% is worth the potential added risk.
When it comes to property, in particular, there are various factors that determine the cap rate, as well as the risk factor involved in investing in that property.
There are as follows:
- The age of the property
- The reliability of the tenants
- The length of the current tenants’ lease
- The amount of property competition available in that market and region
- Larger factors such as total population, country-wide housing culture, and total GDP in relation to living situations.
All in all, the cap rate is an extremely valuable tool in calculating whether a particular property is worth investing in or not.
Although properties with higher cap rates might seem more appealing due to the higher return they can offer, bear in mind that this also comes with added risk, and it may be worth going for a more consistent, ‘slow-burning’ investment just to ensure consistency and reliability.
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