Cap rate is a shortened reference to capitalization rate, which is an illustrative metric used to evaluate the attractiveness of an investment. The cap rate generally identifies how long it will take the investor to recover their investment. You can determine the cap rate using this formula:
Cap rate = NOI (net operating income)/market value.
If the fair market value of an investment is $3 million, and the annual income is $200,000, the cap rate is 6.6 percent. If the market value is $100,000 and the NOI is $10,000 (10,000/100,000), the cap rate is 10 percent.
Cap rates can be one indicator of the value of an investment, but investors need to consider other variables as well in an overall assessment. Location, age, and sector are also crucial elements in the evaluation of property. A higher cap rate is associated with riskier properties, which may allow for a lower purchase price.
Cap rate compression means cap rates are going down.
Factors that support compression include supply and demand, interest rates, and other market conditions. Lower cap rates may correlate to higher property values. Cap rate expansion is correlated to falling prices and lower returns.
Supply and demand within a sector also influence whether capitalization rates are expanding or compressing. Investor demand is typically high for certain property types, including industrial buildings and multifamily housing, which leads to compressed capitalization rates. In a market glut (for example, when retail is over capacity), lower demand for space will boost capitalization rates, which can lead to lower income and potentially lower acquisition prices.
Rising interest rates may also influence cap rates to expand because borrowing costs more. It’s important to note that standard cap rates are calculated as if the investor is using cash for the purchase. Adding interest rates to the equation will alter the outcome.
Is cap rate a good predictor of value?
Cap rate compression impacts property values, or potential appreciation, which is one of the two primary components of investment returns. The other element is income, which is usually less volatile than value. Cap rates are not an ideal indicator of value but can help compare two similar properties in a specific area.
Two properties may have the same cap rate but substantially different prospects. The differences may need to be researched, but investors should consider rental stability, sector demand, and property age and class. Cap rates also change over time. The starting cap rate may be higher or lower than the rate in future years.
Overall, a cap rate calculation is a good starting point for evaluating a property’s potential. Investors will wisely consider whether cap rates are compressing or expanding as part of their overall evaluation of an investment opportunity. It’s also worth remembering the effect that interest rate volatility has on the direction of capitalization rates and as an additional component in the acquisition cost.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.