What Is Cap Rate?

The capitalization rate, often referred to as simply “cap rate”, is used in apartment property financing to determine the rate of return or net gain or loss of profit on an investment over a specified time period that is expected to be generated on an apartment property. Cap Rate is calculated by dividing the net operating income of a property by its market value and is expressed as a percentage. Cap rate is often utilized by appraisers to determine the value of a commercial property and is also the key metric behind the income capitalization approach to property valuation. It is used more often by investors trying to determine the potential return on their investment in the real estate market.

How Do You Calculate Cap Rate?

To understand how to calculate cap rate, imagine a property with a Net Operating Income of $500,000 at a market value of $5,000,000. This property would have a capitalization rate of 10%.

Cap Rate Calculator

Cap Rate Formula:

Capitalization Rate = Net Operating Income / Current Market Value!

In this particular example, $500,000 (NOI) divided by $5,000,000 = 10% (cap rate).

In a lesser used capitalization rate formula, the figure is determined based on the original capital cost or acquisition cost of the target property. the formula looks like this:

Capitalization Rate = Net Operating Income / Purchase Price

However, this version is not as popular since it gives unrealistic results for properties that were purchased several years prior at lower prices. Additionally, this method can't be applied to an inherited property since the purchase price is zero, thus rendering the division impossible.

Another valid consideration is that since property prices fluctuate widely, the original formula using the current market price results in a more accurate representation when compared to the second formula, which uses the fixed value original purchase price.

Understanding and Utilizing Cap Rate in Real Estate

Cap rate is the most widely utilized calculation through which investors and lenders can assess the profitability and return potential on an apartment property investment. Put simply, cap rate represents the yield of a property over the duration of a year. Cap rate also indicates the length of time it will take an investor to recover a staked amount in a property. In other words, a property having a cap rate of 10% would be expected to take around 10 years for an investor to recover the investment amount. Additionally, you can use the relationship between a property’s NOI and cap rate to determine the property value if you know what cap rates similar properties (commercial properties of similar vintage and asset class) are trading for in that sub-market.

While capitalization rate can be useful for lightly comparing the relative value of similar properties on the market, it can’t be trusted as the sole indicator of an investment property’s strength because it does not take some key factors such as leverage into account. Leverage, or, the time value of money and future cash flows from property improvements, is a major metric for investment consideration and financing.

Since capitalization rates are based on projected estimates of future income, it goes without saying that they are subject to high variance. It then becomes imperative for the investor to understand what constitutes a good cap rate for an investment in any given situation. In regards to apartment loan programs, there are no clear ranges for a good or bad cap rate, and the ranges that investors do come to find are typically largely dependent on the context of the property and the market it resides in.