The capitalization rate, sometimes referred to simply as the “cap rate,” is a concept that’s fundamental for anyone buying into real estate for commercial purposes. The cap rate is used in real estate investing to provide a clear ROI of properties. It’s typically depicted as a percentage and its value can vary over time.

Cap rate measures the rate of return on a property without factoring in debt on the asset. The cap rate is a useful metric because it allows property management companies looking to buy or invest in properties to compare one property’s value directly to others. The cap rate is especially useful for assessing the cashflow of rental properties and can help property management companies evaluate whether a property is worth their investment.

What does Cap Rate tell us?

To be able to analyze a property’s capitalization rate you need to be able to compare it to something. In general cap rates differ depending on sector, demographics, and regions as well as other variables. Understanding your cap rate may also require you to log and track changes of one property over time.

A higher cap rate is indicative of more potential cashflow. Across the US cap rates vary for multifamily apartments from one major city to the next. In 2017, the average cap rate ranged from 4.25% in San Diego to 7.25% in Detroit with cities like Atlanta, Philadelphia, and St. Louis in the middle 5% area.

By leveraging the cap rate metric, investors can see the potential value they can get from a property, group of properties, or a market sector. Property management companies or owners can use the cap rate to identify where the value of a property can be improved.

Net Operating Income

You’ll need to know how to calculate your net operating income (NOI) to plug that number into the capitalization rate formula. In general, the NOI is equal to property revenue minus any operating expenses (NOI = Gross Revenue - Operating Expenses). Property income can come from potential and effective rental income. Expenses that should be deducted include vacancy, credit loss, as well as overhead costs.

Calculating the Cap Rate

To calculate the capitalization rate of a property, you divide the Net Operating Income by the Purchase Price or Value of the asset (Cap Rate = Net Operating Income ÷ Price/Value). This formula can be applied to a single property and compared individually with other properties or it can be leveraged to determine the cap rate for a larger group of properties.

Typically, cap rate for a larger group of properties would be categorized by specific property sectors like rental, condo, and commercial or regional differentiators. No matter which qualities are used to segment property groups, a large-scale use of cap rate gives wider market insight.

Fluctuation

Because the variables within a property’s NOI can change, a property’s cap rate can fluctuate which makes it helpful for management firms to regularly monitor the profitability of their portfolio and each property individually.

The cap rates for properties being calculated by value can fluctuate based on interest rates and market demand – all outside of your control. These factors can potentially result in fluctuation even without changes in the property itself or its performance.  

Price or Value

When you’re calculating cap rate you have a bit of a choice whether to input the purchase price or the property value. Typically purchase price can be used to calculate cap rate when presented with an offer for purchasing a property or right after acquiring that property. Property value is a more current and timelier metric because it allows you to calculate a cap rate that accurately represents market value.