The cap rate is one of the most popular metrics to measure a property’s expected rate of return based on current income and market value.
The simple equation is to divide the property’s expected annual net operating income by its current market value: Cap Rate = Net Operating Income (NOI) / Current Market Value
Net Operating Income (NOI) is the value of the net rental rate or operating expenses subtracted from actual income, and the current market value of the property is calculated using a Comparative Market Analysis (which is a tool that real estate agents use to estimate the value of a specific real estate property by evaluating similar ones that have recently sold in the same area)
The basic function of a cap rate is to measure the potential ROI on any given real estate investment.
WHAT DO CAP RATES MEASURE?
It represents the risk associated with an investment: The higher the cap rate, the higher the risk, but also the higher the potential ROI. Inversely, a lower cap rate is indicative of lower investment risk but with a lower payout.
WHEN TO USE THE CAP RATE
In the commercial real estate industry, investors commonly use the cap rate as it’s proven to be helpful in different scenarios, providing investors with a quick assessment as to which acquisition should be chosen over another potential investment.
Cap rates can help investors in trend analysis, giving investors an idea of the direction the market is heading in.
For instance, decreasing capitalization rates may indicate that the market values are going up, which may be a sign that the market is heating up.
WHEN NOT TO USE THE CAP RATE
On the other hand, investors should also know when not to use cap rates. Though capitalization rates fulfill the basic calculation of ROI and serve some predictive function, they cannot account for more complex cash flow processes.
A cap rate should be used for quick valuations and to understand the real estate market fluctuations on a high level. For deeper understandings and to account for all variations of cash flow systems, a comprehensive analysis should be conducted. There are a lot of risk factors to evaluate and consider.
Cap rate calculation may sometimes be a multi-tiered process, but it can help your decision-making.
Interested in purchasing, leasing, or expanding a business? You will want statistics that prove the soundness of a real estate investment. Contact Target Realty Corp. and ask to speak to one of our Commercial Real Estate Experts.
Updated Oct 27
Demand for industrial product continues to soar as online shopping surges and distribution and logistics networks expand with single-tenant industrial product cap rates compressing and prices rising. Cap rates for Single-Tenant Industrial assets dipped this quarter across most markets from 4.91% in Q2 to 4.81% in Q3, aside from Montreal and Halifax which remained unchanged from the previous quarter. READ MORE