What is a Cap Rate
What is a cap rate - A cap rate is
what investors expect to earn as a percentage of their
investment on an annual basis.
Commercial real estate
valuation is
a very
complex
business
with many
variables
that affect
price. Over
the years
investors
found that
they needed
a way to
compare
property
values,
essentially
price, in a
market using
a shorthand
method, thus
capitalization
rates or cap
rates came
into general
use. In
simple
terms, a cap
rate is what
investors
expect to
earn as a
percentage
of their
investment
on an annual
basis.
For example,
a property
with a cap
rate of 10
tells a
buyer that
he should
expect a 10%
return on
his
investment
assuming a debt free transaction.
How to
calculate a
cap rate
-
Formally,
Direct
Capitalization
(cap rate)
is a method used to
convert a property's
annual net income (NOI), into
an estimate of the
property's value.
Value = Net Operating Income /
Capitalization Rate
Cap Rate = Net Operating Income /
Value
In general,
the lower
the cap
rate, the
higher the
property's
value, and
the higher
the cap
rate, the
lower the
value. In
other words, a property with a lower cap rate compared
to a property with a higher cap rate will return less
income to the investor.
Markets like San Francisco, Manhattan, Seattle and
Miami tend to have some of the lowest cap rates in the
country. Properties located in secondary and tertiary
markets tend to have higher cap rates rewarding the
investor for taking additional risk by purchasing in a
smaller market. |
