What is a Capitalization (Cap) Rate?

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cap_rateIf you’ve ever thought about purchasing an income producing property, you probably heard someone talk about the CAP rate. The cap rate is defined as the rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor’s potential return on his/her investment.

The most commonly used formula for determining a cap rate is simply net operating income divided by value. Let’s suppose that you are looking at a commercial building that has five tenants. The asking price is $800,000 and the net operating income is $75,000. By dividing the value of $800,000 by the net operating income of $75,000, you determine that the cap rate is 9.4%.

If you identify an income producing property for sale with a cap rate of 13%, your first thought might be that it looks like a great investment. A 13% return sounds great.

Before you pop the cork on the champagne bottle and begin the celebration, take a closer look. As the cap rate goes up, the price goes down however, risk follows the cap rate. So, the higher the cap rate, the higher the risk.

Some investors are more risk tolerant than others and look to realize a greater return on their investment by assuming more risk. You might be looking at a distressed multi-family complex that is nearly vacant but believe that it can be improved and filled with tenants in a reasonable amount of time. The higher risk associated with this situation provides a lower price and when brought back to life will command a higher price.

You may be wondering about the fact that the higher price point will cause the cap rate to drop and be less appealing to investors. The investors that are less risk tolerant will always be looking for a more secure investment and be willing to accept a lower cap rate in exchange for the greater security.

So how do you decide on an acceptable cap rate? You must view the decision much like investing in the stock market. You can buy less expensive stock hoping that it will go up while you worry or you can buy expensive blue chip stock confident that it will hold its value or slightly increase and be free from worry. It really is a matter of your personal preferences associated with use of your liquid risk capital.

Be careful when taking a look at a property to normalize the expenses. This means you must go line by line and make sure all necessary expenses have been included. Reserve, for example, may have been omitted which assumes no failure of major equipment or roof damage will occur. Reserve money should be on-hand to cover non-recurring expenses that confront ownership. Management is another line item that may be missing. Will you be managing the property or hiring a property management company to do so? When line items are eliminated, the net operating income goes up and the value goes up with it.

Make sure you are well informed so that you can make the best investment decision possible.

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One Response to “What is a Capitalization (Cap) Rate?”

  1. zlteam Says:

    Great post! Lots of great info!

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