The percentage rate of return on a property based on its income
Cap rates provide a quick and simple way to help get a feel for a property’s overall investment potential and a balance with the property’s levels of risk and return on investment.
Cap Rate Formula:
NET OPERATING INCOME / CURRENT MARKET VALUE OF THE ASSET
- Net operating income is the annual income generated by the property after deducting all expenses that are incurred from operations including managing the property and paying taxes.
- The current market value of the asset is the value of an asset in the marketplace.
In simple terms
Hight Cap Rate = low property value
Low Cap Rate = Hight property Value
Importance of Capitalization Rate
The capitalization rate is used to compare different investment opportunities. For example, if all else equal, a property with a 10% cap rate versus another property’s 3%, an investor is most likely to focus on the property with a 10% cap rate.
The rate also indicates the amount of time it takes to recover an investment in a property. For example, if a property comes with a 10% cap, it will take 10 years for the investor to recover his investment (called “fully capitalized”).
Although it’s an important metric in comparing investment opportunities, investors should never base a purchase on the cap rate of the property alone. It is useful to note that different cap rates represent different levels of risk – a low cap rate implies lower risk while a high cap rate implies higher risk. Therefore, there is no “optimal” cap rate – it depends on the investor’s risk preference.
For example, consider two properties in different geographical locations – one is in a highly coveted suburban region while the other is in a run-down part of the city. The property in the highly coveted suburban region would show a lower cap through the high market value of the asset. On the contrary, the property located in the run-down part of the city would come with a higher cap, reflected by the lower market value of that asset.
In a simple world Cap Rate is just one of many metrics that can be used to assess the return on the commercial real estate property. Although the cap rate gives a good idea of a property’s theoretical return on investment, it should be used in conjunction with other metrics such as the gross rent multiplier, among many others. Therefore, other metrics should be used in conjunction with the capitalization rate to gauge the attractiveness of a real estate opportunity.
There’s no set range for which are “good cap rates” — they’re most useful as a comparative tool between a few potential purchase opportunities that are similar in terms of location and kind.
High cap rate properties can be lucrative but also come with an increased level of risk. If you’re new to high-cap real estate investing, it’s best to partner with someone who has the experience and know-how to get a deal done right.
Fathalla DENNO specializes in pairing investors with properties that match their investment profile and risk comfort level while guiding them through the journey of building a secure investment portfolio.
Denno doesn’t stop at listing properties on the MLS system, he prides himself on implementing his own uniquely designed marketing strategy, for hard-to-sell properties, targeted to reach the right clients.
Fathalla DENNO – member, Toronto Real Estate & Hamilton Real Estate Boards
(905) 208-9373 – email@example.com – fdenno.ca
By CFI (Corporate Finance Institute) – Modified by Fathalla Denno