Cap Rate (Capitalization Rate) is one of many real estate metrics used to measure the rate of return on a real estate investment property. It is calculated by dividing the first year’s NOI (Net Operations Income) of the property by the Current Market Value of the property.
Cap Rate = NOI (Net Operations Income) / Current Market Value
This rate serves as an indicator of the potential ROI (Return on Investment) of a given property. A higher Cap Rate indicates a higher level of risk, but a higher return, where a lower Cap Rate indicates a lower return, with a lower level of risk. This calculation is used to compare different investment opportunities and assess the value of a property. The Cap Rate helps investors evaluate the potential profitability of a real estate investment, taking both the income potential and the value of the property into account. It helps investors determine whether an investment is worth making and how much risk is involved.
You have a Current Market Value of $500,000 and an NOI of $100,000.
Cap Rate = $100,000/$500,000 = 0.20 or 20%
This indicates that the property is generating an annual return on investment of 20%, meaning that the property is generating a return of 20% of the purchase price.
What Impacts Cap Rate?
- Location: As with most things in real estate, a property’s location can have a huge impact on the Cap Rate. Properties in a desirable area with good infrastructure will typically have a lower Cap Rate, whereas properties located in undesirable areas will have a higher Cap Rate.
- Property Type: The property type will have a direct impact on the Cap Rate. For example, a Class A multi-family property that is in higher demand will typically have a lower Cap Rate, while a Class C multi-family property with less demand will typically have a higher Cap Rate.
- Market Conditions: Local market conditions can have a significant impact on Cap Rate. When market conditions are favorable, the Cap Rate typically decreases as the perceived risk of investing decreases. Conversely, when market conditions are unfavorable, Cap Rate typically increases as the perceived risk of investing increases. The availability of buyers and sellers, the strength of the local economy, and the current interest rate climate are all factors that can influence Cap Rate.
- Tenants: The quality of a tenant will also have an impact on the Cap Rate. Tenants that are more reliable and have a track record of paying rent on time, better credit, and longer lease terms are perceived as lower risk investments and will typically result in lower Cap Rates. On the other hand, tenants that are less creditworthy and have shorter lease terms may be perceived as riskier investments, which will produce higher Cap Rates.
In summary, Cap Rates and Property Value have an inverse relationship. Lower Cap Rates create higher property values, higher Cap Rates result in lower property values.