What Are Cap Rates?

What Are Cap Rates?

In real estate, the cap rate (capitalization rate) is a ratio of the net operating income (NOI) of a property to its current market value. It is expressed as a percentage and is used to estimate the rate of return an investor can expect to earn from a real estate investment.

The formula for calculating cap rate is:

Cap Rate = NOI / Market Value

Where:

  • NOI = Net Operating Income = Annual rent - Operating expenses
  • Market Value = The current market value of the property

The cap rate is an important tool for investors when evaluating the sell or purchase of income producing commercial property. It can be used to compare different properties and to determine if a property is overpriced or underpriced.

 
"The higher the cap rate the better the return."

 

For example, if two properties have the same NOI, the property with the lower market value will have a higher cap rate. This means that the investor can expect to earn a higher return on their investment by purchasing the property with the lower market value.
 
What would an 8.5 cap rate mean?

An 8.5 cap rate would mean that you could expect an 8.5% annual gross income on the value of your property or investment. If your property's value is $100,000, an 8.5 cap rate will mean an annual return of $8500. A cap rate of 9 on the same property would mean an annual return of $9000, so you can see – the higher the cap rate the better the return.

The cap rate can also be used to estimate the value of a property. If an investor knows the NOI of a property and the desired cap rate, they can calculate the market value of the property.

For example, if an investor wants to earn a 10% return on their investment, and the NOI of a property is $100,000, then the market value of the property would be $1,000,000.

Be aware that while cap rate may be the most popular investment ratio used when evaluating commercial purchases, there are other essential calculations that need to be made. Some of those include Cash Return on Investment (sometimes referred to as cash-on-cash return), Total Return on Investment (Total ROI), Debt Service Coverage Ratio (DSCR), and Gross Rent Multiplier (GRM). See my other articles for information on these calculations.

While the cap rate and other calculations are valuable tools for investors, it is important to remember that there are other factors to consider when evaluating a real estate investment. Other factors, such as the location of the property, the quality of the tenants, and the demand for space in the area, should also be considered. 

 

Did you find this information helpful? Need help determining the cap rate on your current property or a property you’re interested in purchasing? Let me hear from you. I would love the opportunity to assist you.

Disclaimer: I am not engaged in rendering legal or financial advice. The information presented here is not intended to be a substitute for such advice. Readers are advised to consult with a qualified professional for any legal or financial advice specific to their situation.
 

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