What is the CAP Rate and How Do I Use it?
The capitalization rate, known simply as CAP rate, is a key metric in the commercial real estate industry. The metric estimates the amount of profit a potential real estate investor stands to gain from any given investment. To arrive at the formula, a property’s net income is divided by the acquisition cost or current market value as shown below:
The CAP Rate = Net Operating Income (NOI)/Current Market Value
Why the CAP rate is a useful tool in real estate:
Basically, the CAP rate can be used to compare the profitability of similar property investments. For example, let's assume you want to purchase an investment property for $850,000 and you expect to yield $120,000 per year after deducting the operating costs.
The capitalization rate for this investment would be 14.11% based on this simple arithmetic: $120,000 / 850,000 = 0.1411 = 14.11%. Therefore, calculating the CAP rate of every potential property investment you’re interested in will certainly help you identify the most profitable opportunities without breaking a sweat.
However, it’s crucial to understand the context of using the CAP rate. For example, a particular property investment could have a higher value in terms of the capitalization rate than a similar property, yet it may not necessarily be the better investment option.
Judging profitability and risk:
As you can see, the CAP rate is used together with other factors to judge the profitability or risk of potential investments. This ratio is never used in isolation. As such, it's always important for you as a real estate investor to analyze all the factors before making an investment decision.
Lastly, the CAP rate is an important metric for tracking whether a given property is increasing or decreasing in value. If the CAP rate of your property is declining, this is a big indication that your investment is failing. Flipping your property and reinvesting your proceeds elsewhere may be the wisest decision if you find yourself in such a situation.