Understanding Cap Rates

learning cap rates

The commercial real estate industry in North America is heavily reliant on the metric commonly known as capitalization or “cap” rate.  The cap rate is probably the #1 tool employed by analysts and investors in evaluating and choosing rental properties. Cap rates are used to indicate the expected rate of return generated on an investment property.  The cap rate, expressed as a percentage, is calculated as the ratio between the net operating income produced by a property and its original capital cost or current market value:

                                  

Cap Rate = Net Operating Income/Current Market Value

 

There are many other factors involved in analyzing an asset and no single cap rate that is deemed desirable or undesirable – good or bad.  In general, however, properties with higher cap rates are those most frequently targeted by commercial investors.

As with other real estate valuation tools, cap rates are used to compare potential investments.  Let’s say two retail shopping centers in the same market are each assessed in the $10 million range.  Shopping Center #1 generates $900,000 in net operating income (after subtracting annual expenses from the gross rentals received).  Shopping Center #2 has a high vacancy rate and higher expenses, resulting in $300,000 in net operating income. Applying the formula, Shopping Center #1 has a cap rate of 9% (900,000/10,000,000 = .09) and Shopping Center #2, with its vacancies and steep expenses, carries a 3% cap rate (300,000/10,000,000 = .03). 

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When Are Cap Rates the Most Useful?

There are a few important considerations to keep in mind when comparing assets based on cap rates.  For one thing, cap rates are only useful in comparing properties in the same class and the number is only reflective of a snapshot in time as the calculation is based on annual net operating income (NOI).  Cap rates are of little use to house flippers or home buyers not intending to rent the property and the metric does not take acquisition costs and/or mortgage debt into consideration. What the cap rate does provide is a means to evaluate and compare properties based on the current value and NOI.  It also permits a prospective investor or owner to track cap rate trends at a property over time. When the cap rate is employed together with other tools available in an investor’s analytic arsenal, it becomes a highly useful indicator of value. 

Cap rates falling between 4% and 10% are generally considered “good”, but the numbers can vary considerably in different markets.  Properties in inflated real estate markets and high cost-of-living areas such as Vancouver and San Francisco will produce low cap rates, while double-digit numbers are not uncommon in certain rural areas and neighbourhoods undergoing gentrification.  In other words, cap rates are most useful in comparing properties with the same use within the same or very similar markets.  

Good vs Bad Cap Rates

It is also important to understand that there is a high degree of subjectivity attached to the notion of “good” and “bad” cap rates.  Conservative investors will usually look to play it safe and look for properties in a certain sweet spot – those with a high, but not too high cap rate.  Aggressive investors, on the other hand, are attracted to high cap rate properties that carry greater risk, but also the possibility of higher returns.

In an era when real estate continues to promise solid returns, it is critical that new investors possess the knowledge and tools to evaluate and compare properties.  Commercial real estate developers, brokers and lenders conduct business based on the concept of cap rates. An in-depth understanding of this indicator helps buyers and investors separate winning properties from potential busts.  Cap rate is not the only metric that investors must apply, but it’s a good place to start when choosing rental properties.

 

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