Although they are not the first numbers buyers look at when assessing real estate purchases, capitalization rates, also known as cap rates, are a vital aspect of every real estate investment acquisition.
Cap rates estimate the potential return a buyer can expect to receive on an investment in real property. Calculating this number requires investors to determine a building’s annual net operating income (NOI), which is the rental income they expect the property to generate minus deductible operating expenses, and dividing that amount by the property’s purchase price. For example, a building that generates $100,000 in NOI based on historic rental income and operating costs and sells for a purchase price of $1 million would have a cap rate of 10 percent. In other words, the buyer can expect a 10 percent return on a $1 million cash investment in the first year.
Also weighing heavily on cap rate calculations is the level of risk investors will assume based on the location and asset class of a particular income property, the lending environment and the going interest rates. Each of the factors may change from one year to the next. Generally, the higher the cap rate, the more risk the investor will assume. For example, an office building with a few tenants will typically have a higher cap rate than a multifamily apartment building. Similarly, in a rising interest rate environment, it will become more expensive for many investors to purchase income property and cap rates may rise as well.
While cap rates may not be the missing piece of an initial acquisition puzzle, they are a valuable tool to consider for determining longer-term value and feasibility of owning investment property.
The professionals with Orion Real Estate Group work with investors, developers, property owners and brokers through all phases of real estate transactions, from strategic planning and analysis to financing, negotiation, property management and disposition. For more information, call (305) 278-8400 or email firstname.lastname@example.org.