What is the capitalization rate and how can you calculate it?

The capitalization rate (cap rate) is a percentage that estimates the potential return on investment for a real estate property. It's calculated by dividing the property's net operating income (NOI) by its current market value. The cap rate shows the annual return an investor could expect, assuming the property is fully rented and has no vacancies or unexpected expenses.

The capitalization rate, or cap rate, is a metric that evaluates the annual net operating income (NOI) of a property in relation to its market value or purchase price. Expressed a percentage, it's the return an investor would receive if they purchased the property outright with cash and without debt. The lower the cap rate, the lower the return (and risk). The higher the cap rate, the higher the return (higher risk). Cap rates should be used as a basic metric for guidance. They can't always tell you if a deal is good or bad.

Cap Rates ais basically your unlevered yield, that's used as valuation metric against an asset's NOI & purchase price. It's often used to measure the risk and value of an asset, but it also show what you can expect as a return if you were to purchase an asset with cash, hence why it's called the unlevered yield. It also has an interesting relationship with interest rates, when it comes to valuation implications. I'll touch on this in the other sections below.

"What really intrigues me about the Net Operating Income (NOI) is how it captures the real earnings from a property. It includes all the operating costs, but it doesn't include the money spent on financing or big upgrades. This makes a big difference in understanding how profitable a property really is. Then, there's the property's value, which can be tricky and often involves a lot of discussion and expert opinion and comparables. The value changes with the market and is a key part in working out the cap rate accurately."

The capitalization rate (cap rate) is calculated using the following formula: Net operating income (NOI) / Divided by Market Value or Purchase Price The cap rate is a widely used metric in real estate investment to assess the potential return on an investment property.

Investors use cap rates as a baseline metric to judge potential returns on different investments in a market. Cap rates do not take debt into account for a reason. Every property has different debt structures so cap rates help cut out the noise of debt. If two properties have similar NOIs but different cap rates, then the one with the higher cap rate has more risk and return than the one with the lower cap rate. Similarly, if two markets have different average cap rates, then the one with the higher average cap rate has more risk and return than the one with the lower average cap rate.

I've seen some people use 'cash on cash' and cap rate interchangeably, so it's really important to know the difference before you expose your ignorance. A cap rate should be the cost to control the NET operating income (as in after the expenses have been deducted from income), and is under the control of the team. Cash on cash is not 'under the control of the team' because residents might not pay, and sudden expenses can pop up, but is what investors are actually interested in. Put simply, cap rates expose the supply and demand for real estate assets in a particular area, which is why high demand areas have low cap rates (even though it means people pay more for less net operating income!) It's a store of value AND a cashflowing asset!

For me, a cap rate is best used as an evaluation tool for your first pass when evaluating an investment. Is this property in the ballpark when compared to the market cap rates for that type of investment? If it is off significantly, there is probably something you need to know. I do not believe that a cap rate is sufficient information to make an investment decision. Many times, cap rates are calculated for properties based upon pro-forma assumptions rather than actual performance. This is not necessarily inappropriate. There are valid reasons for doing so, but the takeaway is that you can't simply accept those rates without further investigation.

In my experience, Cap Rates don't take into account debt so it's hard to get a true depiction on how the overall asset will be impacted upon acquisition. Even though debt isn't factored into the cap rate, there is a influential piece that impacts cap rates and it has a direct association as to how debt is priced... and that's the interest rate. Interest Rates have a strong influence on how cap rates either expand or compress. As interest rates rise, cap rates tend to expand, which decrease the valuations, and as interest rates decrease, cap rates usually compress, and asset values increase.

Large brokerages publish cap rates for major MSAs (cities), so there really isn't a whole lot of guesswork. But the old trope of 'location, location, location' rears its ugly head once more, because being one or two streets over can change cap rates by a whole percent point! Why? Desirability! Nobody is going to work harder to stockpile wealth if it's going to be looted, burglarized, or otherwise stolen, and hope doesn't get you very far in real estate. So, there's no substitute for knowing your target area and being very well networked within the area! But check out the Marcus & Millichap and other similar sources for reliable market cap info!

The cap rate is a snapshot at a moment in time. It does not reflect any future issues. It can be misleading. There have been discussions about adjusting the cap rate to reflect where the market is headed but this adds an element of subjectivity.

Although the cap rate is a useful tool to value and compare properties, it should be used in conjunction with other metrics such as cash-on-cash return, internal rate of return, and equity multiple, as each metric provides a unique perspective on the investment. Equity Multiple takes into account the potential income to be generated and the property's appreciation over time and measures the amount of cash an investor will potentially receive in return for equity invested, e.g., a 2.0x equity multiple means that for every $1 invested into the project, an investor is expected to get back $2 (including the initial $1 invested). But, the equity multiple alone does not reflect the time value of money, so it's usually presented with the IRR.

Always remember that it takes money to make money. Set your expectations correctly and there’s no reason you can’t make some decent profit.