What is a Cap Rate, and Why Is It Important?
If you’re an investor in commercial real estate, you’ve probably heard of the term “cap rate.” If you’re new to this world, it might be a term you don’t yet understand. What is a cap rate, how is it different from rental yield, and why is it important? Let’s dive in.
What is a Cap Rate and How Does it Work?
A cap rate, or capitalization rate, measures a property’s potential return on investment. In other words, it dictates how much money you should expect to make if you purchase a particular property. Cap rates are also correlated to risk. Let’s delve deeper into how cap rates are calculated, why they are essential for investors, and what is considered a good cap rate.
Cap rates are calculated by dividing a property’s net operating income (NOI) - the income after operating expenses are deducted but before debt service obligations - by its purchase price or current market value. So if a property has an NOI of $100,000 and is valued at $1 million, the cap rate would be 10% ($100,000 / $1,000,000 = 0.10, or 10%). The higher the cap rate on a given property, the more attractive it may be for potential buyers since it means that they can potentially receive higher returns on their investments. On the flip side, the higher the cap rate, the riskier the investment, which generally means that the asset price is low.
It’s all about arming yourself with the knowledge necessary to decide if the presented opportunity is viable and worthwhile.
Typical Ranges of Cap Rates
There is a significant range to cap rates, depending on the type of risk an investor is willing to take. An optimal rate for someone looking for a low-risk investment that offers a steady stream of revenue could be around 4%-5%, while some aggressive investors could look for opportunities more in the 8%-10% range.
Cap Rate Compared to Property Yield
Similar to a cap rate is a property’s yield, calculated by NOI divided by total cost versus NOI divided by price or value. Yield is essentially a rate of return, and depending on the use of debt, there are levered and unlevered yields. A strong yield is typically around 8%-15%. At the time of sale, both cap rate and yield may be similar but will grow apart as time goes on. Cap rate is a reliable ongoing metric, while yield is a fixed number. Understanding both cap rate and yield is essential to discerning the potential return of a real estate investment.
The Importance of Cap Rates
“Taking risk is the only way to achieve extraordinary results — but you have to understand the downside.”
Cap rates offer valuable insight into a property’s potential, helping investors determine whether or not it makes sense to buy that specific piece of property. They reveal important property information - that of the relationship between risk and return. It indicates how much money can be made from renting out the space while considering other factors, such as taxes, insurance payments, and maintenance costs associated with owning that particular piece of real estate. By looking at the cap rate on different properties in different markets, investors can compare various opportunities side-by-side to calculate which one makes more sense financially.
In addition to helping investors decide which properties to buy, cap rates provide insight into market conditions. For example, if cap rates are increasing across multiple markets over time, it could indicate either less demand for rental space or that prices are rising faster than expected. Investors need to adjust their strategic plans accordingly. On the other hand, if cap rates start decreasing, this could indicate strong demand for rental space and/or prices are rising slower than expected, which could be good news for potential buyers since their returns may also increase.
Now That You Know…
Understanding cap rates and why they are essential can help you make informed decisions about where to invest your money. Calculating these numbers for each potential opportunity gives you a reliable gauge of whether or not a piece of real estate will yield high enough returns to justify the investment. It also provides insight into general market conditions, which can help you plan accordingly before making any major decisions about investing in commercial real estate assets.
Understanding all of this will help you decide what kind of risk you’re willing to incur for yourself and better chart your course through the wild and wonderful world of real estate investing and building your own personal wealth.