Real estate investors or other persons regularly associated with investment property undoubtedly have a clear understanding about cap rate (or capitalization rate) and the significant role that cap rates routinely play in real estate investing and investment decision-making.
Cap rate, after all, is certainly one of the most popular rates of return embraced by real estate investors, and probably one of the most calculated returns commonly made by rental property analysts.
As a result, any novice getting involved with investment real estate for the first time will surely be confronted by capitalization rates almost immediately. Yet (not unlike any rental property novice) will undoubtedly not have a clue what the return means or how to calculate it.
This is not a good way for investment property beginners to get started, and does frequently result in some stressful – if not embarrassing – moments when a real estate investor brings it up and they sit there looking dumbfounded. Therefore, we’re going to explain what capitalization rate means in layman’s terms and won’t get hung up on the technical definition or meaning. In other words, we just want to explain it in a way that makes sense to a real estate investing novice servicing rental income property in the “real world” and as it relates to the property, not a textbook.
Capitalization rate expresses as a percentage the ratio between a rental property’s net operating income (i.e., annual rental income less annual operating expenses) and its market value. So think about the rate as the relationship between a rental property’s annual net operating income and its market value.
Net Operating Income ÷ Market Value
= Cap Rate
Let’s say a real estate investor has asked you to figure the cap rates on several rental properties currently listed for sale. One is listed at $750,000 with an NOI of $68,000, and the other $825,000 with $82,000. Moreover, you are expected to suggest which property appears to be the better real estate investment opportunity based upon the result.
$68,000 / 750,000 = 9.07%
$82,000 / 825,000 = 9.94%
Bear in mind, that capitalization rates indicate the net operating income’s percent of price.
Therefore from an investor’s point of view, it stands to reason that the higher the rates are the better. Why, because it suggests that the property produces a higher percentage of net operating income related to its price.
That said, you would suggest to the investor that the property with the capitalization rate of 9.94% appears to be the better real estate investment opportunity.
Rule of Thumb
Cap rates vary from area to area and from investor to investor. So don’t look for one ideal rate – it depends on your local market and the investment goal of your real estate investors. Moreover, they don’t provide a true picture of a rental property’s profitability, so never make real estate investment decisions based upon a cap rate alone.