Real Estate Foundations: What is a Cap Rate?
Let's start off with the basics here: "Cap" rate is short for “capitalization rate.” This represents a basic formula:
Cap Rate = Net operating income (NOI) / the current market value of the asset
It’s one of the most popular formulas in real estate and is often part of the discussion between an investor/buyer and a broker/seller. Why? Read on to find out.
A better understanding of the cap rate will help add to your education as a sophisticated investor, or you might just simply be someone who likes to read and learn about real estate. In this article, we’ll explain why.
Why does this matter to investors?
Cap rates are important because they’re used to distinguish the returns of various investments. At first glance, one investment might seem better than another. Let’s say, for instance, you’re looking at two properties: one of them is in a big, bustling city and the other is in the suburbs, about an hour’s drive away from the first property. Let’s imagine that the property in the city brings in $1500/month and the property in the suburbs brings in $950/month.
At a first glance, some investors might say that the first property is the better investment because it brings in the most money. But this isn’t necessarily true at all.
And you can use the cap rate to help you figure out why.
Calculating Cap Rate
Using the example provided above, let’s calculate the cap rates for two hypothetical properties to find out how they might compare.
First, you need to find out the net operating income. That’s all the money you have coming in (revenue) minus management costs, taxes, maintenance, insurance, and any other expenses that are not capital expenditures or debt service.
So our property in the city is a duplex that pulls in $1500/month. That’s $18k/year. After you factor in all of your other expenses, you’d really only be making $12k/year on the property, which an appraiser valued at $280,000.
The property in the suburbs pulls in a less flashy $950/month. However, taxes are pretty low, at only $1.5k/year. After you calculate all of the other expenses, it brings in roughly $9k/year. An appraiser valued this property at $150,000.
The cap rate, then, for our first property is: $12k (our net operating income) divided by $280k (the value of the asset). The result? 4.2%
However, the cap rate for our second property is $9k (our net operating income) divided by $150k (the value of the asset). The result for this property? 6%.
A higher cap rate will mean you are paying less for a given stream of income versus a lower cap rate. A lower cap rate will mean you are paying more for a given stream of income or asset class.
How does this factor into a purchasing decision?
Cap rate is merely one input into the equation, but does allow you to compare properties within a sub-market or across markets. At Redline, when we are evaluating investments, we will look at cap rate trends over time as a measure of market sentiment. A higher or lower cap rate alone does not mean a great or poor deal, but rather a measure of demand for a given asset class that is taken into consideration at the time of purchase.
Cap rates can and will vary at the same point of time across markets and across asset classes. Higher demand or high growth areas typically demand a lower cap rate vs. less populated or areas in less demand.
We hope you've enjoyed this article! To learn more, please reach out to us at any time at firstname.lastname@example.org.