What Is Cap Rate and Why Is It Used to Value
Investment Property?
Capitalization Rate or “Cap Rate” is one of the most common ways real estate investors
determine property value and a potential return on an investment property. While determining
cap rate isn’t the only way to evaluate an investment property, it is considered one of the most
important metrics for investors to know.
Not only is it important for investors to determine cap rate, it’s equally important to make sure all
of the numbers within the cap rate formula are as accurate as possible. In this blog, we will
share how to accurately determine a property’s cap rate and help investors decide when to
move forward with an investment or not.
So, what does Cap Rate mean?
Cap Rate is the annual rate of return that is expected to be generated on a real estate
investment property. Cap rate is also the most common way to access profitability and return on
a real estate investment. This metric helps buyers determine the expected return on investment,
prior to factoring in mortgage financing. The Cap Rate shows the property’s un-leveraged rate of
return.
When Should You Use Cap Rate
A cap rate should be used to evaluate a buy-and-hold investment property, prior to purchasing.
It can also be used if you own an investment property and plan to sell it. Before putting it on the
market, you should also determine your property’s cap rate. If you have already purchased an
investment property and have not done this step, now is the time to do so.
Cap Rate can be used in the following types of Real Estate:
- Single Family Investment Properties
- Condo and Townhome Rentals
- Commercial Real Estate
- Multi-Family Rentals
- Apartment Rentals
When Not To Use Cap Rate
There may be times when using cap rate doesn’t make sense when looking at an investment
property or helping a client sell or buy one. Generally, a cap rate should never be used for the
following:
- A Flip: If you plan to use this investment strategy, you won’t be receiving any potential rental income since the purpose is to fix and flip for more.
- Purchasing Land: When purchasing land, cap rates are useless because it’s nearly impossible to determine the NOI on vacant land.
- Purchasing a Vacant Property: Similar to purchasing land, Cap rate is dependent on NOI so it will be difficult to determine your possible rental income.
- Short-Term Rentals: Since cap rates are determined by annual rental income, short term rentals can skew your realized take home for the year.
- Vacation Rentals: Cap rates on vacation rentals do not accurately depict the value of the purchased property, because most of these properties are not rented year round.
How to Calculate Cap Rate
Cap rate is calculated by the Net Operating Income or “NOI”, divided by the purchase price or
value of the property. An accurate purchase price can be determined by looking at recent sale
prices or comparable properties in your area.
When calculating NOI, you cannot factor in the annual expenses such as; utilities, property
taxes, property maintenance and repairs, or property insurance. After you have determined the
NOI and purchase price, the cap rate can then be applied to the property you’re buying to show
the current market value based on income. The cap rate also helps buyers determine if the
asking price for the property is reasonable.
Factors That Can Affect Cap Rate
Cap rates vary among residential and commercial real estate. The following factors may affect a
cap rate:
- Location: Typically, a property in a good location or neighborhood means a higher market value which means higher rent.
- Asset: The type of property such as apartments, single-family, multi-family or commercial properties can affect the value of a cap rate. Generally, commercial properties have higher cap rates than residential.
- Inventory: The lower the inventory, the higher the demand. How many properties that are available in the area impacts the cap rate as well.
- Interest Rates: Higher interest rates lead to lower cap rates.
Cap Rate Limitations
Cap rate can be harder to determine if a property is new or less than 5 years old, because the
net operating income doesn’t have enough rental history and expenses to accurately determine
your cap rate. Newer properties do require less maintenance, but to truly receive the higher cap
rate, think about purchasing property over 5 years old.
Conclusion
So now that we know what cap rate is and all of its limitations, you’ll be able to more accurately
determine the value of a property compared to its expenses. Ultimately, having the tools decide
a higher or lower cap rate, and which works best for you and makes the most sense for you and
which works best for your investment strategy will be an important factor to successfully earn
the cap rate you’re looking for.
Want to learn more about Cap Rate?
Sea Coast, Real Estate Academy, offers dedicated courses designed to prepare you for your
new real estate career in North Carolina. Contact us today to get started!