The cap rate (capitalization rate) is defined as the Net Operating Income divided by the market value of the real estate asset. The Net Operating Income should be expressed as the annual return on the property minus the operating costs. The market value would be the current market value.
The formula for cap rate is as follows:
Capitalization Rate=Net Operating Income/Asset Value
Here is one way of looking at the cap rate of a property. It is the percentage return that an investor would realize on an all-cash property acquisition. You could use this figure to compare multiple properties or compare a property to another type of investment such a securities.
Let’s suppose John buys an income property for $800,000 that has a Net Operating Income of $100,000. Using our formula his capitalization rate is $100,000/$800,000 or 12.5%. John will earn a profit of 12.5% each year on his $800,000 investment. Now let’s suppose that his property is in a rapidly appreciating neighbor hood and it’s value increases to $1,200,000 rather quickly. Keeping in mind that cap rate involves the current market value we need to recalculate John’s rate at the newly appreciated value. Now we have $100,000/$1,200,000 producing a cap rate of 8.33%. (Assuming the income has remained the same.) With John’s percentage return declining he probably needs to 1) attempt to get his Net Operating Income up or 2) consider selling the property and reinvesting in another property providing something closer to the 12.5% he originally earned.
One way to look at the cap rate of an investment property is to compare the property’s cap rate to the percentage return on a risk-free investment. There really are no totally risk-free investments. However, the return on U.S. Treasury bonds is often used to compare an income property investment to a relatively risk-free investment. Let’s assume that an income property valued at $1,000,000 has a Net Operating Income of $60,000 and a cap rate of 6.0%. Let’s also say that U.S. Treasury bonds are returning 3.0%. Investing $1,000,000 in this real property would yield a 3% greater return than investing the same $1,000,000 in U. S. Treasury bonds. The question becomes, “ Is the additional 3% return from the real property worth the additional risk and work.” After all, you could just buy the bonds, go relax, and count your income. Some of the risk factors to consider when putting a value on the additional income from the real property might be: tenant tenure, stability of the neighborhood, economics of the area, and age of the property.
Bearing in mind that location is so important in real estate we know that properties located closer to downtown will typically have higher value. This will potentially make cap rates vary from neighborhood to neighborhood for a given property type. Different types of properties exhibit different cap rates as well. For these reasons, the cap rate has limitations in its usefulness in comparing investments. Cap rate comparisons are most useful when comparing similar properties in similar neighborhoods.
For example, Class A office space varies greatly from city to city around our country. Most rates will fall into a range of about 4% to 8% depending on the city. This is simply an example of one property type to give you a rough idea of what kinds of numbers to expect.