If you’re thinking about getting into real estate investments, one crucial concept you have to familiarize yourself with is the Capitalization Rate, or the “Cap Rate”, which it’s better known as. A cap rate signifies a property’s natural rate of return without taking the debt on the asset into account, thus making it easier to compare the relative values of properties.
How Cap Rates are calculated
If you understand finance but are new to real estate, just think of cap rates as the opposite of price-earning (P/E) ratios used in the stock market. Whereas price-earnings ratio measures the market value, or price, of a stock divided by its earnings per share, the cap rate calculates the yearly income of a property divided by its value, or cost.
Cap Rate = Annual Net Operating Income/Price (or value)
What Does a Cap Rate Signify?
To put it in a nutshell, a cap rate calculates a property’s yield in a one-year period, making it easy to compare the cash flow of one property to another’s with factoring in any debt on the asset. In other words, it signifies the property’s unleveraged, natural rate of return.
The cap rate is also used to measure the risk in a real estate investment. What return can you expect given the risk of the specific asset or property? For instance, properties that are older and have fewer credit-worthy tenants may be riskier, and therefore, would have a lower price and a higher cap rate. The property’s condition and location, the length of the lease in place, and the diversity of the tenants can be potential factors that contribute to the risk premium and thereby, affect the value of the property, and subsequently, its cap rate.
When are Cap Rates Used?
Considering the illiquid, relatively complicated nature of the commercial real estate, it can sometimes be quite difficult to calculate valuations. This is where cap rates can be highly useful. An effective comparative tool, they allow investors to evaluate potential real estate investments on a more apple-to-apple basis. Cap rates are used consistently by both buyers and sellers to decipher trends in a given market and to evaluate fair pricing.
When Should You Not Use Cap Rates?
We’ve already established that when appropriately used, cap rates can serve as a useful evaluation tool. However, a real estate investment should never be made solely on the basis of a cap rate. In fact, cap rates don’t even apply in some cases. For instance, they are of no use if you’re evaluating short-term investments, such as fix-and-flips, where your main objective is to exit quickly with a sale. These types of investments don’t involve any rental income, which is why they can’t be measured on a cap rate basis.
One of Houston, TX’s leading commercial lenders, Global Capital Partners Funds provides effective real estate financing solutions, including hard money loans. Get in touch with them to learn more about the services they offer.