Cap Rates Explained for Investors

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The capitalization rate, most commonly known as cap rate, is one of the fundamental concepts in real estate investing. Even though it is among the essential concepts, there are plenty of investors who do not understand it entirely or are misunderstanding it – which is relatively common as well.

If that’s the case with you, fear not, as this article will act as a guideline for understanding cap rates.

What Is a Cap Rate and How It’s Measured?

A cap rate is a figure that measures a property’s natural rate of return in a timeframe of one year. It doesn’t account for debt though, which makes it easy to determine and also easy to use for comparison of relative values of different properties.

As we said, a cap rate measures the return rate, and it does that with a simple calculation:

A cap rate is equal to the annual net operating income divided by the cost or value of the property.

This simple measurement tells us how much a particular property will yield in a one-year timeframe.

However, you can also think of the cap rate as a way of measuring the risk in a deal. Essentially, when you measure the cap rate, you can determine whether a property is worth the risk of investment or not.

For example, a property that is both older and has fewer credit-worthy tenants, carries more risk for you as an investor, making it have a lower price. All of this results in a higher cap rate.

It is not all – several things can influence the value of a property and thus its subsequent cap rate:

  • Length of leases in the property

  • Property’s condition, how old it is, the rate of wear and tear, etc.

  • The diversity of its tenants

  • The location of the property

Naturally, the cap rate on its own is a simple percentage, but it’s not easy to know which percentage is good as it always depends on the context. You can read more about that here.

When You Should and Shouldn’t Use Cap Rates

Commercial real estate is relatively complex and illiquid today, and cap rates can ease this as they provide a comparative tool when searching for potential investments. Both sellers and buyers rely on them all the time to evaluate a fair price and decipher the current market trends.

However, there are instances where it’s not okay to use them. On their own, cap rates are not good enough for determining whether an investment is good or not. On top of that, sometimes, cap rates don’t even apply.

For example, you can’t use them for evaluating short-term investments where your objective is to make a quick sale. These properties can’t generate income on rent which is why the return rate cannot be measured based on a cap rate. Additionally, cap rates cannot be used in cash-on-cash returns.

The Current Trends

What we can tell you for sure is that today, cap rates are at an all-time low as most real estate across the US has a very high value. Precisely because of this current trend, you need to be aware of how cap rates work. For more information, you may reach us at info@LLCPM.com