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Are you interested in investing in real estate, but feel overwhelmed by the complexities of the industry? If so, understanding cap rates is an essential part of the process. In this beginner’s guide, we’ll explain what cap rates are, how they’re calculated, and how to use them to make informed real estate investment decisions.
What is a Cap Rate?
According to Pickett Sprouse Commercial Real Estate broker Emilee Collins, CCIM, “the cap rate is the rate of return on the income that is expected on a property in the first year of holding.”
Pickett Sprouse broker Brad Gregory adds that “cap rate is a form of measurement that does not include debt.” In short, it’s a metric that helps investors measure and compare the potential profitability and risk of different investments. It can be used to assess a property’s investment potential and determine whether it’s a good fit for a particular investor.
As Feldman Equities explains, it is expressed as a percentage and generally has an inverse relationship to the property value. “The lower the cap rate, the higher the purchase price and vice versa. Properties with higher cap rates tend to have more inherent risk, while those with lower cap rates tend to carry lower risks.”
How is a Cap Rate Calculated?
A property’s cap rate is calculated by dividing its net operating income (NOI) by its purchase price. Emilee says the calculation is to divide rental income minus expenses (NOI) by the market value or proposed purchase price of the property. Let’s use a property that generates $100,000 per year in net operating income as an example. If you purchase the property for $1 million, you’ll have a cap rate of 10%. But if you purchase the same property for $500,000, you’ll have a cap rate of 20%.
Factors That Affect Cap Rates
There are several factors that can affect a property’s cap rate. Location, credit worthiness (rating) of the tenant, and amount of landlord responsibilities are a few of the most significant. Other factors include repairs and maintenance needed to the property, property taxes, the length of the lease agreement, and the cost of utilities. If a property’s cap rate is significantly lower than the average cap rate of the market, you can use these factors to help determine whether the property is a good investment.
Emilee does caution though that it’s important to remember “the actual return an investor receives is subject to change from the initial cap rate if expenses or income change due to unexpected vacancies and repairs.”
Benefits of Understanding Cap Rates
The advantages of understanding cap rates are numerous. Understanding the metric behind a property’s net operating income allows you to make better comparisons between different properties and alternative investments. If a property’s cap rate is higher than the market’s average cap rate, it’s likely overpriced. On the other hand, if a property’s cap rate is lower than the average cap rate, it may be a good investment opportunity.
In that way, you can use the average cap rate of a particular market to determine whether the property you’re looking at is priced appropriately. If the average cap rate of a market is 10%, but the property you’re analyzing has a cap rate of 12%, it may be overpriced. While the average cap rate of a market is just a guideline, it’s an excellent place to start your research.
As we told you in this article on Multifamily Investment Strategies for Beginners, you also need to know what your goals are when considering cap rates. If your end goal is for cash flow in the short-term, then buying a property in an area where there is less demand but a higher cap rate may be the best option. If appreciation is your goal, then buying a property in a location where the cash flow isn't going to be great but where the value of the property will appreciate may be where you're going to be able to make your money in the long-term.
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Our brokers and other partnering commercial real estate experts will be answering your questions every month through the Ask a Broker series. If you have a commercial real estate question that you want answered, we’d love to hear from you at marketing@westandwoodall.com.