Capitalization Rate Part 1
You've undoubtedly heard the term before, but what does it mean, what is Cap Rate? Cap Rate, is short for Capitalization Rate, and if you do a quick Google search, the definition is not all that clear.
Investopedia explains Cap Rate as "This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market."
Okay, so what does that actually mean!?
What it means, is that, if you were to purchase the real estate asset with all cash, the Capitalization Rate would reflect your Cash on Cash Rate of Return.
For example, if you were to purchase a $100,000 investment property at a 6% Cap Rate, and pay for it with cash, no financing involved, you would expect to make $6,000 after clearing operating expenses.
Capitalization Rate = Net Operating Income / Current Market Value OR Purchase Price
So are Cap Rates the best metric to use when looking at investment property? Cap Rates can be a great metric for assessing property value, and using a comparatively similar metric across multiple properties and markets. However, the difficulty with Cap Rates is that they are usually based on pro-forma financials or poor information, and there is no standard pro-forma used across the real estate industry. If one person estimates for 5% maintenance expenses, and the next person estimates for 10% maintenance expenses, the pro-forma net income will be different, and that will make the Cap Rate different as well. Drag that discrepancy across 10 different expense line items, and you can create a very different investment picture. Do you see the issue this can create?
In addition to the discrepancies in pro-formas, a majority of investors will use financing to purchase assets due to the benefits leveraging money has to offer (an article for another time). When leveraging an asset with debt, an investor can expect to make a better return than what the Cap Rate would indicate. Capitalization Rates do not account for leverage, property improvements to be made to a property, or future cash flow increases.
Overall, Cap Rates are a great way to quickly assess a property's relative value. However, Cap Rates should not be the only metric or factor used in assessing a property's value. There are multiple other metrics out there, that when combined with a Cap Rate, can provide an excellent estimate of a property's value and its estimated return.
Reach out to Monarch Real Estate to learn more about how we analyze properties and investment offerings.
Monarch Real Estate is a full-service real estate firm based in Sioux Falls, South Dakota.