UNDERSTANDING AND UTILIZING CAP RATES

by Matthew Roberts, Certified General Real Estate Appraiser

July 2016

Capitalization rates, or as many professionals refer to them, cap rates, is a concept in real estate which allows analysis of a property’s value and performance. It is a ratio between annual net operating income and property value, and is most often expressed as a percentage. So, Cap Rate = Net Operating Income / Property Value. For example, if a property has a net income of $50,000 and is worth $500,000, then the cap rate would be .10, or 10%.

While the method may seem simple, its use as a tool in real estate investment and valuation can be very helpful. For example, investors can use cap rates to determine rate of return, income potential, and required cash investment. Income potential and rates of return are common to a variety of property types, not only commercial property, but agricultural properties as well. So cap rates have a broad application across several kinds of real estate.

Cap rates can also be used as a direct calculation of one year’s net income as opposed to the discounted cash flow method (a common alternative), which may be better for long term, irregular, or complex streams of income. The direct cap method is widely accepted and easy to use but is rarely the only factor used in making a real estate investment decision. This method provides a snapshot of a property at a given time but may not be able to take into account expected increases or decreases in potential income or market demand not driven by income.

Market trends can become clear when analyzing cap rates of certain property types. For instance, a low cap rate tends to indicate low risk and high demand on a market level of net income, and a high cap rate can indicate a high level of risk or lack of potential income for a property. As a side note, cap rates and income multipliers are inversely related.  As a cap rate goes down, the income multiplier goes up.

Furthermore, several components can influence the capitalization rate of a property. Investors take into account several factors: alternative investments and differences in risk, age of the property, risk of tenant default, market demand, required return, etc. However, cap rates do not consider the costs of financing as part of the investment equation. Rather, it helps estimate return on a cash investment, and borrowers will have to anticipate a profitable difference between rates of lending costs and investment returns.

Cap rates can be helpful, but not understanding their purpose and use can lead to misusing or misapplying them, which would result in inaccurate results. Understanding, analyzing, applying, and projecting capitalization rates is something we do every day at Spurgeon Appraisals. We have the knowledge and experience necessary to accurately value the return on your real estate.

Spurgeon Appraisals regularly appraises a variety of property types. We have experience appraising farms, residences, and commercial properties. We pride ourselves on providing excellent customer service and quality appraisals. Contact our team to see how we can meet your appraisal needs and exceed your service expectations.