Cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. The cap rate simply represents the yield of a property over a one-year time horizon assuming the property is purchased on cash and not on loan. The capitalization rate indicates the property’s intrinsic, natural, and un-leveraged rate of return.
Capitalization Rate = Net Operating Income / Current Market Value.
When And When Not To Use Cap Rates:
- Cap rates are typically used by real estate investors to compare the risk involved in multiple commercial properties. Although you can use cap rates to inform other real estate investment decisions, it may not be as helpful.
- If you are considering the cap rate as a way to evaluate potential properties, don’t forget that there are many tools to help you. You can use other metrics to determine risk levels and the potential returns of an investment property.
- Cap rates can be an effective tool for commercial properties. But you shouldn’t use this formula to determine the value of single-family homes, properties with irregular income streams, or properties that you intend to flip immediately.
The higher the Cap Rate, the higher the perceived risk and the lower the price. Conversely, if the Cap Rate is lower, the property is perceived to have a lower risk.
Since most of us buy properties using loans, cap rates are not too important metrics. Cap rate is a very important metrics for a metrical estate syndicate.