What is the CAP rate?
The capitalization rate is a metric in the form of a percentage used to reveal the rate of return of the investment property over a one-year time span. The CAP rate is shaped by the net operating income and the appraised value of the property.
How is it useful?
The ratio answers vital questions for investors such as:
- What is the rate of return?
- Is the property profitable?
- Is the performance below or above market?
- Should an investor sell the property?
- Is the rent below or above market?
- Is this property in a robust or weak market?
- Should an investor acquire additional properties in this market?
- How valuable is this property compared to others in the market?
How do investors calculate the CAP rate?
Disadvantage
Investors should use additional metrics when analyzing an investment property as the capitalization rate doesn’t encompass the property’s leverage, time value of money, nor future cash flows.
Example
CAP Rate = 20%
Cap Rate = $5,000,000 / $25,000,000
Appraised Values = $25,000,000
Property = $25,000,000
Net Operating Income = $5,000,000
Revenue = $6,250,000
Operating Expenses = $1,250,000
What does a 20% CAP rate mean?
Assuming that the average capitalization rate of the market in which this property is located is 18%. The investor can conclude that a 20% CAP rate means the property is overperforming the market by 2%. Based on the property’s market value, the investor is generating 20% of his property’s value per year. This means the investor will recover the investment in 5 years (100% / 20%) while his competitors will recover their investment in 5.56 years (100% / 18%). In this case, an investor may look to acquire additional properties in this market.
Assuming that the average capitalization rate of the market in which this property is located is 30%, the investor can conclude that a 20% CAP rate means the property is underperforming the market by 10%. Based on the property’s market value, the investor is generating 20% of his property’s value per year. This means the investor will recover the investment in 5 years (100% / 20%) while his competitors will recover their investment in 3.33 years (100% / 30%). In this case, an investor may look to sell the property.
Investors with properties in different markets use the capitalization rate as a key indicator to decide what market they want to exit and which ones they want to enter.
What is the optimal CAP rate?
The optimal capitalization rate varies by market. Investors don’t have a clear definition of a strong or weak capitalization rate. CAP rates are defined as strong or weak based on the market’s average. Investors use the market’s average to measure if they are underperforming or overperforming.
