What is a Cap Rate in Real Estate?

Since real estate investors don’t have crystal balls they can consult when considering which properties merit their investment capital, they turn to cap rates instead. 

Capitalization rates are an important part of investment analysis because they provide investors with insight into the potential rate of return on prospective investment properties. This can be a useful tool in weighing investment risk versus potential reward. 

Let’s take a closer look at how to determine cap rate on investment properties. 

How to Calculate a Property’s Capitalization Rate 

In order to determine a property’s capitalization rate, take the asset’s net operating income (NOI) and divide it by its market value. Here’s the formula and an example: 

NOI/market value = cap rate 

Asset value: $10 million 

Net operating income: $600,000 

Cap rate: 6% 

The example above shows potential investors that they can expect approximately 6 percent operating cash flow each year for the price they paid for the asset. If they paid the $10 million in cash, they would have to wait 16.6 years to see their full investment capital returned. 

Generally speaking, the higher cap rates equal increased risk but also the potential for greater returns. By converting the property’s net operating income into a value, investors can use a property’s cap rate to determine a year’s expected unleveraged income and its value. 

Factors that Affect Cap Rates 

Location to major employment centers and key transit corridors can affect capitalization rates. Submarkets situated in well-trafficked and stable locations typically have lower cap rates on investment properties due to high investment demand. Less-desirable or transitory neighborhoods typically have higher cap rates due to population and employment swings and lower demand, which often lead to increased tenant turnover that causes fluctuations in a property’s cash flow. 

Cap rates also can vary among asset classes. Industrial buildings and multifamily investment properties usually have the lowest (compressed) cap rates, especially in strong primary real estate markets, due to high investment demand and lack of available product. However, as investors chase yield and move capital into secondary and tertiary markets, they create stronger investment demand and competition in these markets, which raises property values and lowers cap rates.  

Broad market shifts also can lead to lower cap rates. The rapid rise of ecommerce, hastened by the pandemic, has led to higher investment demand in industrial distribution properties, corporate grocers and retailers, and tenants in essential service industries. Limited supply and fierce competition for investment opportunities across these sectors push asset pricing upward. 

Other factors that can influence a property’s cap rate include its age, tenant type and mix, lease structure, and regional macroeconomic factors that could pressure tenants’ operations. 

Putting it all Together 

Cap rates are a common metric used to weigh an investment property’s income potential against its purchase price. High cap rates translate to higher income-generating potential, while compressed cap rates equal lower cash flows. 

Cap rates are a useful metric to compare investment properties, but they don’t look at important factors such as leverage, the value of investment capital over a set time frame, or the potential to increase net operating income through improvements or rental increases. Cap rate isn’t a reliable metric for assets that may have fluctuations in operating income since the formula for determining cap rate is predicated on stable cash flows. 

While cap rate has its place in property analysis, investors should consider a wide range of additional valuation metrics when conducting due diligence on potential investment properties.