A capitalization rate (cap rate) is a key metric used by real estate investors to evaluate potential returns and analyse property values.
What is a Cap Rate?
In simple terms, the cap rate is the ratio between the net operating income produced by an investment property and its current market value. It is calculated by dividing the net operating income by the property value.
Mathematically:
Cap Rate = Net Operating Income / Current Market Value
The cap rate expresses the relationship between the income generated by a property and its market value. It shows the expected rate of return an investor can anticipate from owning that property.
How Cap Rates Relate to Property Values
Cap rates have an inverse relationship to property values. In other words:
- Lower cap rates correlate with higher property values
- Higher cap rates correlate with lower property values
For example, a property valued at $1 million that generates $100,000 in net operating income has a cap rate of 10% ($100k / $1m). If the property value increased to $2 million but the income remained the same, the new cap rate would be 5% ($100k / $2m).
So as a property becomes more valuable, its cap rate declines. And vice versa – if values decline, cap rates move upward.
What Factors Influence a Property’s Cap Rate?
Many factors impact cap rates, including:
- Interest rates – Lower interest rates reduce cap rates, while higher rates push them upward.
- Market conditions – A strong, growing economy typically causes cap rates to fall as demand rises. Weaker conditions cause rates to rise.
- Location – Properties in prime locations usually have lower cap rates than secondary locations.
- Property type – More stable assets like government tenanted offices tend to have lower cap rates than volatile assets like hotels.
- Lease terms – Long lease terms lower risk and decrease cap rates. Short leases raise rates.
Using Cap Rates in Investment Analysis
Analysing cap rates is useful for real estate investment in several ways:
- Comparing deals – Cap rates help investors rank and select the best investments. Lower cap rates signal greater returns.
- Upside potential – Investors look for ways to increase NOI and decrease the cap rate through renovations, better management, higher rents, etc.
- Risk assessment – Higher cap rates indicate increased risk. Investors must determine if the returns justify the risk.
Cap Rate Trends Over Time
Historically, cap rates tend to decline over long periods as property values rise. But there are short term fluctuations based on economic cycles.
In weaker economies, values fall increasing cap rates. In peak economies, property prices surge decreasing cap rates as returns become compressed.
Limitations of Using Cap Rates
While useful, cap rates have some limitations investors should consider:
- They don’t account for potential property value growth and appreciation.
- NOI fluctuations caused by increased expenses can raise cap rates.
- Cap rates don’t factor mortgage expenses, only investment returns.
In summary, capitalization rates help assess property investment potential and values. But they should be used in conjunction with other metrics for a complete analysis.
