What is Cap Rate?

Posted On: May 8, 2019
cap rate

For the most part, we talk about residential real estate on this blog. It has a lower barrier to entry, involves a larger volume of properties and clients, and the deals move faster.  Plus, you can do it part-time. For all those reasons, more agents start with residential rather than commercial. Commercial real estate is higher stakes and harder to get into. Brokers deal in office buildings, retail sites, apartment complexes, undeveloped land, and other commercial property.  Their clients are real estate investors or businesses. As such, commercial brokers need to be fluent in business and finance. Large brokerages won't even consider hiring you without a bachelor's in a related field. So if you're interested in focusing on commercial real estate, you should find out ASAP whether or not you have an aptitude for those concepts. Let's start with a common and relatively simple metric in commercial real estate known as cap rate (short for "capitalization rate").

Defining and Calculating Capitalization Rate (Cap Rate)

For real estate investors, the "cap rate" is one of several metrics for assessing the value of an investment property.  It's the anticipated yearly rate of return—the amount of money the property will make in a year measured against its value.  You calculate it with the formula: Capitalization rate = Net Operating Income (NOI) ÷ Current Market Value where NOI = Expected Gross Income (Year 1) ÷ Expected Operating Expenses (Year 1) You'll calculate the Gross Income as the rental income at 100% occupancy.  You should add any other income the property might bring as well (like facility/venue rentals, parking, vending, laundry, and other service charges). Operating expenses include:

  • Property taxes
  • Insurance
  • Property management fees
  • Maintenance & repairs
  • Common utilities
  • Licenses
  • Vacancy/credit loss reserve (i.e., empty rentals + renters who don't pay what they owe)
  • Pre-rental rehab costs, if applicable
  • Other expenses (like those that support your "other income")

The formula doesn't consider mortgage or closing costs at all.  It treats the transaction as an all-cash sale.  Cap rates allow you to compare properties' merits alone, without the complications of financing.  If you want to assess the return with financing costs, you would use Return on Investment (ROI) instead. Since no one is a fortune teller, you should base all these numbers on what you can reasonably expect, either by using on the property's current income and expenses or similar properties nearby.

What are Cap Rates Used For?

Cap rates are popular and practical tools.  You can use them to:

  • Measure profitability and return potential on prospective investments
  • Measure the risk of an investment (the higher the cap rate, the riskier an investment it is)
  • Compare the return potential and risk between properties
  • Assess the risk/return potential of entire markets by geography, property type, etc.
  • Choose the best market and sub-market to shop in
  • Study trends for indications of whether a market is heating up or cooling down
  • Compare cap rates to non-real estate investments to decide whether to buy property at all

Cap rates are only useful as a point of comparison. The meaning of a particular percentage varies by city, neighborhood, property "class," and purpose.  Buying retail property is riskier than buying a multi-family residential property, so retail cap rates are higher. Buying an older building in an "up and coming" neighborhood is riskier than buying a new building in a good location. The question of whether you want to go with higher or lower cap rates depends on your client's perspective and investment strategy.  If your clients are looking to buy a low-risk, hands-off investment, then you want to steer them to properties with a lower cap rate that will perform as-is.  If your clients are willing to take on greater risk for greater reward, you'll want properties with higher cap rates and the potential for improvement.

The Takeaway

Cap rates are one of the simpler concepts you'll need to master if you want to become a commercial real estate broker. If that's not for you, residential may be the best choice. Either way, you'll need to become a licensed real estate agent. Taking your pre-licensing courses online is an efficient and affordable solution for completing the requirements. You can work through courses on your own schedule, around your existing obligations, to meet your state's licensing requirements.

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