Gauging the financial return from a rental property is critical when making a real estate investment decision. While there are a number of valuation tools available to investors, a building's capitalization rate helps determine the rate of return from an investment property in the first year after purchase.
Cap rate is a measure that makes it possible to compare properties even though they produce different levels of operating earnings. It serves the same purpose as an earnings multiplier does for stock investors. The ratio of price/earnings, often called a PE ratio, allows investors to compare one company to the next. A cap rate is simply the inverse of the PE ratio. It is the the first-year operating earnings divided by the price or value.
Put another way, a cap rate is the return on assets, sometimes called ROA, of an investment property. To compute a cap rate, which is short for capitalization rate, the first-year net operating income (NOI) is divided by the price or value, as expressed in the equation below:
Cap Rate = Net Operating Income ÷ Purchase Price or Value
The NOI is almost always a smaller number than the price. That is because buyers can usually expect real estate to generate cash flow for several years. This makes buyers willing purchase at a price that is higher than the amount returned in just one year. The ratio of NOI over price shows the share of the price the buyer will receive back by the end of the first year of operation. The cap rate equation does not take into account the impact of debt financing. Instead, it assumes that buyers pay all cash.
Cap rates are typically used as an initial gauge to estimate whether a price is reasonable given the NOI a property produces, after which other valuation methods can be used to come up with a better estimate of market value, as discussed further on the How to Find the Market Value of Investment Real Estate article.
Cap rates and market values fluctuate with variances in the cost of capital, expectations for NOI growth and investor perceptions about risk, or the chances for volatility in the income stream over the expected holding period. Naturally, investors will pay more for assets when the cost of capital is low, when the income growth is high and when the risk to future cash flows is low.
While using the cap rate helps gauge financial returns from an investment property, it does have its limitations. First, the formula measures a return from a property for a fixed time window of 12 months. Additionally, the cap rate for an investment can be hard to gauge. A new property has little to no history of operating expenses or generated revenue, which can skew the final cap rate calculation.
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