Understanding The Cap Rate

The capitalization rate, or solely cap rate, is an essential part of the real estate world. Therefore, precisely understanding its features is crucial for making smart business decisions. Considering a cap rate before buying or selling, might give you a clear perception of the property potential.

What precisely is a cap rate? It is the ratio of Net Operating Income to the property asset value.

Cap rate = NOI / Value

Before taking a deep dive into the topic, let's explain briefly about Net Operating Income as well, since it is one of the principal parameters in the formula. NOI includes the number of cash flow after operating costs, but before principal and dividend returns, depreciation, capital outgoes.

NOI = Rental Income + Additional Income -Vacancy Losses – Total Operating Expenses

Now, we can go into further discussion about the cap rate. 

What is the cap rate telling us?

Assume we are researching the recent sale of a multifamily residence. 

Sale price = $2,000,000 and NOI=$180,000. Let's calculate the cap rate.

Cap rate=NOI/value=180,000/2,000,000=9%

So, our cap rate is 9%, which is an excellent result.

How to interpret our estimations?

Capitalization rate gives us an approximate image of:

1. The probable income - The amount of cap rate defines the possible income you should be waiting to get from the property.

2. The existing condition of the market - cap rate can be a good indication of the market positioning. If the prices are very high in the area, it indicates that other parameters will be significant.

When you have equally good properties and can't decide between them, the cap rate might help you. The higher is the price, and the better is the capital.

What is considered a reasonable cap rate? It depends on your status. If you are a seller, a low cap rate is better. However, from the buyer's perspective, you should focus on the higher cap rates.

Conclusion

To sum up, the capitalization rate is a significant indication of property in the real estate industry. It gives you an understanding of what to expect from a particular investment. At the same time, it helps you decide between similar properties.