Cap Rate: How to Calculate and Use it in Real Estate Investing

Raintree Blog Capitalization
When investing in real estate, the capitalization rate, commonly referred to as “cap rate”, is used to help understand the projected rate of return on an investment property.
Simply put, the cap rate is calculated by dividing the Net Operating Income (“NOI”) of the property by its current market value. The result, expressed as a percentage, is the cap rate.
Cap Rate Calculations
For example, let’s say you’re looking at a property that has a current market value of $100,000 and brings in $12,000 after all operating expenses. To calculate the cap rate, you would divide the net operating income by the market value:
Cap Rate Formula
What this means is that if you were to purchase this property for $100,000, and all other factors remained the same, you could expect to earn a 12% return on your investment.
However, the 12% return only tells one side of the story: income. What happens if the income stays the same, but the market value changes?
If income stays the same and market value increases, then the cap rate would decrease. Likewise, if income stays the same and market value decreases, then the cap rate would increase. As you can see, there is typically an inverse relationship between the cap rate and its market value. This is not a golden rule as there are always exceptions to this, however it does beg the question why would one investment property have a higher or lower cap rate versus another? The answer is typically associated with industry trends and the risk inherent with that type of real estate investment. Generally, the riskier an asset is, the higher the cap rate as the potential rate of return needs to be higher (the asset needs to be cheaper) in order to compensate for the additional risk.
When calculating and analyzing cap rates, it is also helpful to understand how they compare to the broader industry and how cap rates for similar assets have evolved over time. If they are steadily decreasing, then it is likely that the market value is either increasing, the income is decreasing, or the market value is increasing at a greater pace than the income. This may also indicate that more and more investors are targeting similar assets, therefore driving up prices. If cap rates are steadily increasing, then the opposite scenarios could be true, and it may pose as an opportunistic time for investors to buy underpriced assets (buy low, sell high).
So, understanding cap rates can be useful when making an investment decision, however, they should also be compared against the industry and overall industry trends. If an apartment building has a cap rate that is very different from the overall industry, you would want to understand why. A great opportunity or perhaps something to avoid?
Cap rates alone should also not be used to make real estate investment decisions. Rather, cap rates should be considered along with other factors such as location, property condition, projected future income, real estate trends, quality of the tenants, leverage, etc. Cap rates are one tool in an investor’s toolbox in analyzing real estate investments.
If you’re considering investing in real estate, understanding cap rates is a good place to start. With this knowledge in hand, you’ll be able to more accurately compare properties, project their potential rate of return, and better understand your investment options.