Capitalization rates (or cap rates, as they are more commonly called) are one of the most popular returns associated with real estate investing.
As such, it’s not uncommon for a cap rate to appear in a real estate analysis inside reports like an APOD or proforma income statement.
Those of you who have been engaged with rental income property for any amount of time are certainly already aware of this. So to you, capitalization rates aren’t a mystery.
On the other hand, beginner real estate agents and investors with less rental income property experience would naturally have questions and want to know more in order to make proper use of this popular return.
So it seemed needful for me to present an overview.
Meaning
Capitalization rate is the rate at which you discount future income to determine its present value.
But this is the technical definition and really will mean little to you in the real world, so allow me to generalize what it means in practice: A cap rate expresses the relationship between a property’s value and it’s net operating income.
Net Operating Income / Property Value = Cap Rate
In other words, it shows what percentage of a property’s value (or sale price) is attributable to its income stream.
This is significant to real estate investors because net operating income is the amount of cash flow available to make the mortgage payments. And in cases where the investor is making an all-cash purchase without a mortgage payment, the cap rate is virtually the investor’s rate of return on that income stream.
It stands to reason, therefore, that real estate investors would want to base their investment decision on the highest capitalization rate possible.
Remember, higher capitalization rates mean more net operating income related to price and therefore imply a higher rate of return produced for the investor by the investment, and vice versa.
Application
Cap rates are routinely used by real estate investors, agents and analysts for several informative reasons.
- To gauge and compare the financial performance of various real estate investment properties. This is helpful when multiple rental property’s are being considered.
- To determine whether the asking price of an income property is in line with the price comparable income properties recently sold. This helps to prevent paying more than market value.
- To establish an asking price for an investment property about to be listed for sale based upon local market values.
Nuances
There is no such thing as an “ideal” or “standard” cap rate. Capitalization rates for real estate are market driven.
- Foremost, they are based upon the real estate investor’s personal investment objective, which, of course, is highly arbitrary and does vary from buyer to buyer.
- Secondly, they are based upon the property’s location, rent stability, condition, neighborhood risk and appreciation potential. You would not expect a relatively new property located in a well-kept neighborhood near a city’s growth corridor to have the same value to a buyer, for instance, as an older property in need of repair located in a deteriorating part of town.
- Thirdly, they are based upon the geographic market location of the real estate. An apartment complex located in Orange County, California, for example, would likely support higher values marked by lower capitalization rates than a complex located in Detroit, Michigan.
So You Know
All ProAPOD real estate investing software solutions automatically compute cap rates and include them in the appropriate real estate analysis reports.
