Why is a Cap Rate Important?

Cap rates are one of the go-to tools real estate investors use when valuing a property. Cap rates provide a quick and easy way to determine a property's value. But cap rates shouldn't be used in isolation. Understanding how to derive a cap rate and knowing the right context are critical factors in getting the most out of a cap rate. 

Valuing By Cap Rate

The cap rate is a ratio that divides NOI (net operating income) by the property's market value. It can be calculated using the following formula:

Cap rate = NOI / value of property

As an example:

$1MM: current market value

$100,000: NOI

= 10% cap rate

The value of a property is the current market value. NOI is calculated as revenue minus operating expenses, taxes, and insurance. Mortgages are not part of NOI or the cap rate calculation.

The lower the cap rate, the higher the property’s value. The opposite is also true — a higher cap rate equals a lower property value.

A higher cap rate can indicate a lack of demand in the area. But it's important to understand the local area and how the property fits in (i.e., context). Some investors try to buy at a higher cap rate, assuming the property/location is a good bargain. A lot goes into determining if the property is a bargain. Cap rate alone won't tell the full story.

Some examples will help us better see which cap rates might indicate a bargain.

Cap Rate Examples

If the average or market cap rate in an area is 5% and you find a similar property for 7%, from a cap rate perspective, you are buying the property at a discount. An investor buying a property in this neighborhood at 5% simply buys at the market rate. If an investor were to buy at 4%, they would immediately take a loss.

Here’s what all three of the above cap rates might look like:

$500,000: market value

$25,000: NOI

= 5% cap rate

$357,000: market value

$25,000: NOI

= 7% cap rate

$625,000: market value

$25,000: NOI

= 4% cap rate

The advantage of the 7% cap rate is that the property has room to appreciate, assuming property value mean reverts to the average $500,000 property value.

What if you can improve your NOI? On a property that was purchased for $700,000, you start with an annual NOI of $40,000 and a cap rate of 5.7%:

$40,000 / 5.7% = $700,000

Then, when it comes time to sell, you’ve increased the annual NOI by $10,000:

$10,000 /5.7% = $175,438

That’s equity growth. Adding the $175,438 of new equity over the holding period plus the original purchase price provides a value of $875,438, which doesn’t include any increase in the property’s market value.

Investors can manipulate the cap rate formula. For example, if you have the NOI and cap rate, you can determine the property’s value, as we did above:

Price to pay = NOI/cap rate

As an example:

$50,000/ 6% = $833,333

Note that the cap rate generally looks at a one-year period. It isn't as useful for determining the value over multiple years.

Once you add location, gentrification, comps, and other factors, cap rate calculations can become very involved. That's why it's worth working with a local, experienced realtor when looking at potential properties.