In commercial real estate investment analysis, one metric that is often used is "cap rate." Based on its name, cap rate means capitalization rate, and it provides a simple yet powerful way to value a property's net income relative to its market value. While it is not a comprehensive measure of investment return, it is often used to compare the relative income potential of different properties. When it comes to selling a property, executing a 1031 exchange, or rebalancing your portfolio for retirement, it is important to know about cap rates to make better decisions on your investment property wealth.
How Is a Cap Rate Calculated?
The cap rate is the ratio of a property's net operating income (NOI) to its current market value. The formula looks like this:
Cap Rate = Net Operating Income / Property Value
For example, if a property generates $100,000 in annual NOI and is worth $2 million, the cap rate is 5%. This rate is helpful for investors who want to know their potential return if they buy the property with cash (without a mortgage).
Note: Cap rate does not include financing considerations, tax effects, or potential appreciation, and should be used in combination with other financial metrics when evaluating an investment.
What Does a Cap Rate Tell You?
The cap rate can be thought of as a quick way of looking at the risks and rewards of a property:
Higher cap rates may reflect greater income potential, but they often signal higher perceived risk or operational uncertainty. Such properties are found in emerging locations or those areas with operational problems and have cap rates of 7% and above.
Lower cap rates are typically associated with properties in prime locations or with longer-term leases to high-credit tenants, which the market may perceive as more stable. These are considered more stable but typically yield lower returns, usually from 4% to 5%.
Cap rates represent how investors in a given market evaluate a property's income potential relative to risk factors such as location, lease terms, and tenant creditworthiness.
Why Cap Rates Matter for Property Owners
If you are an existing property owner, understanding cap rates can support more informed decision-making. It is a metric that can help you to:
Estimate Property Value: By dividing the net operating income of your property by a typical cap rate for your market, you will get an approximation of the property value. This is a general valuation approach and should be supplemented with other methods.
Assess Sale Timing: When cap rates are compressing (yields are declining), it usually means that property prices are rising due to an inverse relationship, which could be an indication that it could be a time to sell or exchange.
Assess Replacement Properties: If you are planning a 1031 exchange, cap rates can be used to compare the potential replacement properties based on their return and risk, though other financial metrics and risk factors should also be considered.
Align Investments With Life Goals: A lower cap rate investment may be suitable for those who want stable income and low volatility – significant for retirement or estate planning.
At Realized, we work with clients to transition equity from actively managed properties into diversified, passively held portfolios. In our proprietary due diligence process and portfolio construction, cap rates are an important tool to match risk profiles to tailored Investment Property Wealth Management strategies.
A Word of Caution
While cap rates are a valuable tool in real estate analysis, they are only one piece of the puzzle. Other factors, including the condition of the property, the quality of the tenants, the length of the leases, the state of the local economy, and the tax implications, also need to be taken into account. This is why Realized takes a research-based approach when assisting investors in their real estate wealth.
If you’re exploring how to structure your real estate portfolio more intentionally, contact the Realized team to learn how metrics like cap rate fit into a broader investment strategy.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
