Capitalization Rate

What is a good cap rate for an investment property?

What is capitalization rate?

The capitalization rate (cap rate) is used in commercial real estate to indicate the rate of return that is expected to be generated from an investment property.  The cap rate is computed by dividing the expected net operating income by the property value and is expressed as a percentage. The cap rate is an asset’s unlevered (no mortgage) return, and a reflection of the asset’s relative risk.

The cap rate can be useful for quickly comparing the value of similar real estate investments in the market, though it should not be used as the sole indicator of an investment’s strength. Buyers use cap rates as a way to determine if they are getting a good deal on a property by comparing it to the prior sales prices of other similar properties in the market. Sellers use cap rates as a marketing tool to show buyers how the list price was determined as well as show an asset’s potential yield.

How to calculate capitalization rate?

The capitalization rate of a real estate investment is calculated by dividing the property's net operating income (NOI) by the current market value as shown here:

Capitalization Rate = Net Operating Income / Current Market Value

The net operating income is the expected net annual income generated by the property and is arrived at by deducting all the property expenses from the gross income. These expenses include regular upkeep, insurance, management fees, as well as property taxes. The current market value of the asset is the present-day value of the property.

Looking at an example, say you’re considering purchasing an office building as an investment property. You can purchase the building for $1,000,000 and you estimate that it will generate $90,000 in annual rental income and have yearly expenses of $30,000. You can subtract property expenses from the rental income to get the property’s expected net operating income of $60,000 ($90,000 - $30,000 = $60,000).

Dividing $60,000 by $1,000,000 gives us 0.06 and multiplying by 100 gives a cap rate of 6.0%. However, the natural question is, "is this a good cap rate?"

Interpreting the capitalization rate 

Cap rates are subject to variance. Because of this, it is important to understand what constitutes a good cap rate. There is no definitive range for a good or bad cap rate as it is largely dependent on the context of the property and the market. In general, a “low” cap rate of 3-5% would mean the asset is lower risk and higher value. A “higher” cap rate of 8-10% reflects a lower price, higher risk and higher return. If you do choose to use cap rate in assessing a property, you must determine what you believe to be a suitable cap rate for a given level of risk.

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