What is a cap rate? A cap rate is simply a formula for figuring out the ratio of a property’s net operating income to it’s purchase price. In other words, it’s the estimated percentage rate of return that a property will produce on the owner’s investment. Cap rates are used for measuring the risk of an investment property. The higher the risk, the higher the cap rate. Conversely, the lower the risk, the lower the cap rate.
Capitalization rate is calculated using the current market price on the property over a specific period. When the market price is stable, the rate does not change. However, as prices rise or fall, the rate can change. For example, if property values in your area rise by 10 percent, and the next year, your property is valued at $110,000, your capitalization rate for the second year would be 15,000/110,000 or 13.6 percent.
As you can see, your cap rate has fallen. If you anticipate that market values will continue to rise in your area, you will need to consider increasing your NOI (Net Operating Income) by bringing in more revenue or cutting more expenses to bring your capitalization rate back up.
One way to assess risk for your real estate investment purchase is to start with a few major factors that could affect cap rates.
How do Macro-Level Economics and Demographics Affect Cap Rate:
Let’s say you buy a property in a major metropolitan area like Los Angeles – a big city with a strong, diverse economy. It also has high demand from a constant influx of real estate renters and buyers .
At the same time, Los Angeles has a lack of new construction supply due to land shortage and regulatory restrictions.
These macro-level economic and demographic factors can positively affect real estate values and that usually makes the real estate in a place like LA less risky for investors to invest their money.
In terms of cap rates, this means LA has low cap rates (i.e. high prices). And this means investors and property owners there are more willing to accept lower-income returns because of the lower perceived risk.
On the other hand, the economic and demographic fundamentals of a rural or small town market are different. Locations such as these are economically not as strong as a growing, big city that has a diversified economy. So, investors here demand higher cap rates to compensate for this risk.
How do Local Markets Affect Cap Rate:
Some micro-level locations within the same market are better than others. To reflect this, commercial real estate buildings are organized into four classes (A, B, C, and D) based on their location and building condition.
At a basic level, simply keep in mind that Class A means the newest, best located, and more in-demand buildings. And B, C, D get progressively older and less desirable. Investors in each class of property will demand different cap rates.
As you can see, the cap rates increase as you move to lower property classes. This doesn’t mean you shouldn’t invest in Class C or even Class D, it just means you need to understand the risks and figure out how to address them.
How Do Different Property Type Affects Cap Rate:
Imagine you purchase a residential apartment building in suburban Orlando, FL. The market cap rate for your apartment building will typically be less than the cap rate for a small retail shopping center in the exact same location.
What’s the difference between residential and retail? Risk.
During a recession, people will still need to live somewhere. So, an apartment building will likely stay full, even if rent rates are a little lower.
However, a small clothing boutique renting the retail location might go out of business during a recession. The owner of the building could face long vacancies and much lower rents.
Asking the simple question – What is a cap rate? Can really help you understand the potential risks or reward associated with a particular commercial real estate investment.