Along your real estate investment journey, it won’t be long until you see someone mention “cap rate.”
Cap rate, or capitalization rate, is a handy metric used to evaluate the risk in properties and find suitable investments. Many firms will boast about their cap rate to demonstrate their ability to choose their properties, but what does capitalization rate mean? What impacts it? And how can you interpret it to make the right investment decision?
We’ll answer those questions and more as we dive deeper into capitalization rates and what they mean in real estate.
What is the capitalization rate?
The capitalization rate, or cap rate for short, is a key metric used in real estate to compare properties.
In simple terms, the cap rate measures the estimated annual return from a rental property. The cap rate evaluates the risk of owning a property by analyzing its income compared to its underlying value.
How Cap Rate is Different from ROI
When discussing returns, it may be tempting to think cap rate and ROI are the same. They’re not, though; this is a crucial distinction to remember.
Cap rate estimates the projected annual return for a property, whereas ROI represents the overall return on your investment in a property. In other words, somebody can use the cap rate to compare potential investments to assess risk and potential return, while ROI will be the return realized after investing in a property.
What does Cap Rate mean in Real Estate?
As you can guess, the cap rate is a handy metric for comparing two (or more) different properties.
Real estate investors love it because it allows them to forecast the ROI of a property. It calculates the ratio of net operating income compared to a property’s market value, enabling you to determine what percentage of its value is profit. Cap rates allow real estate investors to decide whether they will hit their ROI targets or if they have an unprofitable investment on their hands.
How is Cap Rate calculated?
The cap rate formula is simple; it only uses two variables:
- Net operating income (income – expenses)
- Property market value
To calculate the cap rate of a property, divide net operating income of a property by its market value like this:
Cap rate = net operating income/property market value
Here’s an example:
Suppose you have a multifamily property worth $10 million, generating $700,000 of net operating income from renting the units. The cap rate for this property is 7%. To know what this means, though, you’ll need to know how to interpret and compare a property’s cap rate.
How to Interpret Cap Rate
You’ve got the formula, so what does it mean?
Cap rate shows you the net income ratio of a property compared to its market value. A positive cap rate means that the property is generating income. A high and positive cap rate means the property generates a high percentage of revenue compared to its market value. Be aware, though, that higher cap rates mean higher risk.
Positive cap rates mean a higher likelihood of generating a positive ROI, whereas negative cap rates mean the property is losing money and likely to be a poor investment.
What is a “Good Cap Rate”?
There is no single value for a “good cap rate,” but it is important to be able to interpret a cap rate and make a judgment call as to whether it is good or bad for you. Many analysts will say that a good cap rate is between 5% – 10%, but here’s a helpful way to think about it: the higher the cap rate, the higher the potential return and the higher the risk.
This is true for all investments. Risk is simply a measure of volatility for an investment. Risky investments have a chance to go up quite a lot, but they are just as likely to drop. Less risky investments will lead to more modest returns and smaller losses. There is no single cap rate to aim for, but you should do your due diligence in investing with the right firm.
What affects the Cap Rate of a property?
There are quite a few factors that can impact the cap rate of a property. They all stem from factors that impact the real estate market; here are a few common ones:
- Rental growth rates: When rents go up, so does the property’s operating income, which impacts its cap rate.
- Property values: Because the denominator of cap rate hinges on the property’s value, then economic factors that impact property values will impact the cap rate for a property.
- Location: Locations that are high in demand lead to stable but lower cap rates due to the higher property values. Meanwhile, locations that are growing in demand can result in higher cap rates due to the higher rents compared to the property value, however these carry more risk.
- Market size: Similar to location, the market a property is in will affect its cap rate.
Understanding these facts is critical to choosing the right property or market to invest in, and cap rate is one of several handy metrics to compare properties as you decide what to invest in.
Are you ready to invest in real estate?
By now, you have a solid foundation for determining and comparing a property’s cap rate. Are you ready to take the next step in your investing journey by investing in real estate?
There are numerous advantages to investing in real estate, such as:
- The ability to build passive income
- Diversification of your portfolio
- Several tax advantages
If you have the appetite for it, real estate is an excellent way to diversify your investments and build wealth over time.
The key takeaway from this article is that the capitalization rate is a key metric in evaluating a real estate investment, and there is quite a bit of nuance to it. It’s not so simple as property A has a cap rate of 5%, and property B has a cap rate of 6%. You need to be able to interpret the cap rate and understand how well the investment aligns with your investment goals.
We don’t blame you if all of this is starting to get a bit overwhelming, and fortunately, we’re here to help. At Colony Hills Capital, we are experts in the acquisition, ownership, and management of properties in growing markets around the country, aiming to provide consistent and above-average passive income to our investors.
While we cannot guarantee results, we always strive to deliver consistent and above-average passive income to our investors. Past performance is no guarantee of future results.
Interested in investing? Contact us today to learn more.