The capitalization rate, often referred to as the “cap rate”, is an important fundamental concept used in the world of commercial real estate. It is the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor’s potential return on his or her investment.
Commercial real estate investors use capitalization rates to value properties. When you can raise rents without increasing expenses, your net operating income (NOI) increases. Since cap rate is a ratio of net operating income to the property’s value, this is a positive thing.
The capitalization rate of an investment can be calculated by dividing the property’s net operating income (NOI) by the current market value or acquisition cost of a property, expressed in the following formula:
Capitalization Rate = Net Operating Income / Current Market Value
In summary, the capitalization rate (aka cap rate) is defined as the first year “stabilized” net operating income (NOI) divided by the present value (or purchase price).
What is the Advantage of Using Cap Rate to Analyze an Investment?
The cap rate is a convenient and quick method to determine if the value or purchase price of an investment meets the investor’s criteria. The cap rate alone, however, should not be the sole reason to purchase a property. Investors must perform proper due diligence and consider other factors such as location, demographics, growth, supply vs demand, loan-to-value and debt coverage ratios to determine if an investment is worth the risk.
What are the Disadvantages of Using Cap Rate to Analyze an Investment?
The main disadvantage in using the cap rate to analyze an investment property is that the cap rate only shows the value of a property based on the first year’s stabilized net operating income. If the NOI of a property changes in subsequent years, the cap rate changes, therefore the value. The cap rate has an inverse relationship to value. Assuming the NOI remains the same, if the cap rate increases, the value decreases and vice versa.
Is it Better to Have a Low or High Cap Rate?
The answer to this question depends on who is evaluating the property, and why. Investors (buyers) want to have a high cap rate, meaning the value (or purchase price) of the property is low. Conversely, landlords (sellers) want to see a low cap rate because the selling price is high.
Factors such as loan amount, property type, age of the property, tenant, location, credit history, economic condition, etc. all play a significant role in determining appreciation rate, and ultimately value, of commercial properties.
Therefore, before investors rush out to purchase a property, do not just analyze the investment based on the cap rate. Proper due diligence needs to be performed to see if decisions are made based on real data.
Investors (buyers) want to have a high cap rate, meaning the value (or purchase price) of the property is low. Conversely, landlords (sellers) want to see a low cap rate because the selling price is high. … Even though Property A has a higher net operating income (NOI), the interest is higher.
If NOI rises while the market value does not, the capitalization rate will rise and, if the opposite happens, the capitalization rate will decline.
For a real estate investment to remain profitable at a certain level, NOI needs to increase at the same rate as the property value increases, or at an even greater rate.
In the near term, cap rate increases can have a dramatic impact on property performance. But, real estate performance is less sensitive to cap rate changes as the investment horizon lengthens. Time has the potential to heal most, but likely not all, wounds from rising cap rates through the magic of compounding annual NOI growth rates.
NOI growth can have a powerful impact on property values; the stronger the growth, the greater the protection against adverse movements in cap rates. This last point has important implications for property and market selection and suggests a strong preference for investments with solid NOI growth.
Ask a dozen economists about the effects of rising mortgage interest rates on the housing market, and you’re likely to get two dozen answers. You see, it isn’t simple marketplace, and the interaction between interest rates and performance is really dependent on who has a stake.
For example, home buyers obviously don’t like seeing interest rates rising, unless they’re lucky enough to already be in a transaction with a mortgage rate lock. It makes homes less affordable and forces decisions about buying less of a home or continuing to rent. Those potential buyers who are saving for a down payment or working on repairing their credit are at risk of rising rates during their preparation.
The home buyer perspective is simple, the lower the interest rate, the lower the payment, and the more I can get for my money. When rates fall, it spurs home buying. But, rates have been historically low for years now and the housing market has only experienced what many would call a weak recovery. When rates rise, it certainly doesn’t help overall.
For Real Estate Investors it is more of a glass half full for real estate investors when mortgage rates are rising. Sure, if you’re getting a mortgage to purchase a rental home or commercial property, you’ll incur greater expense and lower cash flow. But, this negative is usually fully offset by benefits to investors. But when buyers aren’t buying, they have to live somewhere. They rent, and the rising demand for rental properties increases occupancy rates. This reduces vacancy costs, with more renters renewing leases rather than shopping again and moving when properties are scarce.
Rental Rates are related to occupancy, it’s just good old “supply and demand” in action. Reduce the supply and/or increase the demand and prices rise. When occupancy rates are high, rents can usually be increased without a significant effect on vacancy costs.