October 1, 2020
When you’re looking to invest in CRE, you have a lot of options in front of you. How do you quickly and efficiently narrow down your options without eliminating good opportunities? One of the fastest ways to get a feel for your best options is to look at the cap rates of different properties.
Defining Cap Rates
Before hearing the arguments for why the cap rate is a good measurement for comparisons, it’s useful to understand where the cap rate calculation comes from and how it works.
The long form of “cap rate” is the capitalization rate. This is percentage of your investment you can expect to get in returns annually, based on the market value of the property and the net operating income it’s generating.
Cap rates are calculated with a simple formula. Take the net operating income (NOI) of the property and divide it by the market value of the property, which is often either the asking price or most recent sale price. Take the answer and multiply it by 100 to turn it into a workable percentage.
- NOI = $50,000 annually
Market Value = $500,000
50,000/500,000 = 0.10 x 100 = 10% Cap Rate
What the Cap Rate Represents
Cap rates are a quick way to estimate the expected returns from a property with a specific level of investment. While it’s a good metric to know, it’s not an all-encompassing measure. For instance, because the cap rate is calculated using NOI, it doesn’t give a final picture of your total profits particularly if you use debt to finance the purchase or if there are extra capital expenditures.
Cap rates do not take into account all the relevant factors for an investment property. They are simply one of many metrics that helps you understand the potential returns on an investment before you do your full due diligence.
Comparing CRE Investments Using a Cap Rate
The important thing to remember about cap rates is that there is no good or bad cap rate. This metric isn’t designed to tell you which investments are objectively better than others. Instead, it’s a scale to help you compare what to expect from one property over another.
- Analyze risk more accurately across different markets
- Calculate the fair market value of a property in local context
- Assess the performance of various properties
Generally speaking, cap rates give a snapshot of a property’s financials. They’re used as a broad metric that provides a quick glimpse into the potential investment. If the cap rate meets your standards, you can narrow down your list and take a closer look at only the investments that are promising to you.
Higher cap rates tend to indicate higher risk investments whereas lower cap rates indicate low risk properties. Property value appreciation tends to operate inversely to cash flow in CRE, meaning higher cap rates tend to point to lower property value appreciation while lower cap rates tend to indicate higher property value appreciation.
Average cap rates vary based on the local and broad market conditions and the type of property. While hotels tend to have the highest cap rates, new multifamily buildings or offices in urban areas tend to have the lowest. It’s highly dependent on the inherent risk of the investment, the conditions locally, and potential for the property to gain value over time.
Comparing the cap rates of two properties in the same local market generally gives you a good picture of what to expect from each.
Why Use Cap Rates?
Using a cap rate measurement gives you a quick and easy way to get a feel for an investment in any local area. As long as you can get a picture of what the average cap rates are for a certain asset class in your target location, you’ll be able to find the properties that suit your investment preferences more quickly.
Due diligence takes a lot of time and effort. It’s better to save this effort for only the properties that have the most potential to align with your priorities as an investor.
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