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Capitalization Rate (Cap Rate)

Posted by Tyler Gracey on Monday, October 19th, 2020 at 2:57pm.

 

| What is a Cap Rate? | 

A metric used to gauge the approximate risk and rate of return on an income-producing asset, assuming the investor paid cash.  A cap rate is expressed as a percentage and derived by dividing the Net Operating Income (NOI) by the sales price or current market value.

Formula: Capitalization Rate = Net Operating Income / Current Market Value

Example:

Net Operating Income: $150,000

Current Market Value: $2,000,000 

Net Operating Income ($150,000) / Sales Price ($2,000,000) = 7.5% Cap Rate

 

In short, this means that you would have an approximate return of 7.5% if you paid cash for the property.

You may ask, is this an effective way to value a property? 

There are a handful of variables that are not factored into this measurement.  For instance, cap rates do not factor in future cash flows, financing, or the time value of money to name a few.

It is a quick way to gauge the proposed financial return on the investment and is most beneficial when comparing multiple real estate deals of similar form and function.

 

| The Higher the Cap Rate the Better |

We often hear this, but is it always true?

Perhaps, like many things in both life and the real estate industry, we have to look at it from different perspectives.  Are you the buyer or are you the seller?

The cap rate has an inverse relationship with market value.  Typically speaking, the lower the cap rate the higher the value and the higher the cap rate the lower the value.

Typically, sellers are going to want to see a lower cap rate on their property, indicating a higher market value. The opposite of that is usually true from the buyer’s perspective.  Many buyers would like to see as high of a cap rate as possible, as they are seeking a higher return and lower purchase price.

Since a cap rate is also a measure of risk, too high of a cap rate can pose the question of whether or not there are factors that impact the property negatively and actually drive the market value down.  Location can be a major factor for this.  A less desirable or lower trafficked area may put downward pressure on market values, which could increase the cap rates.

While the high cap rate may look favorable from a percentage standpoint, there may be more to the story.

 

| Blowing the Whistle on Cap Rates |

The asset or property type, location, and other various market forces can have a positive or negative impact on cap rates.  Furthermore, cap rates may not have as much weight as one might think unless other comparable property sales have sold with similar cap rate numbers.  If there were 10 sales of similar property type that recently sold in a localized geographic location, all hitting a cap rate of 7.5%, it would be pretty safe to say that the next comparable property could sell at or around a 7.5% rate because you have real sales data to back it up.  These are the instances where cap rates have a heavier weight.   Alternatively, when there is little to no recent sales data of comparable property type and location, it bears the question of what an appropriate cap rate may be.  This is where we use other valuation methods to cross-reference and come to an educated conclusion on what makes sense for placing a value on a property.  In general, utilizing a cap rate should not be the sole metric used to underwrite a deal.  There are many other factors that should be taken into account.

This is where a professional real estate advisor that is well versed in investment real estate comes into play and can assist you with providing the necessary information to make an educated decision.  

At Seaport Commercial, we pride ourselves on having the proper tools, resources and experience necessary to aid our clients in making sound real estate decisions.  We hope to have the opportunity to work alongside you on your next commercial real estate deal.

 

 

TYLER GRACEY Real Estate Advisor

c: 860.510.3020 | tyler@seaportre.com

12 Roosevelt Ave, Mystic, CT

Group Qualifications to be your Guide: B.S. Real Estate & Urban Economics (UConn) MBA, Former Appraiser, Graphic Designer, Social Media Expert, Top 1% of Agents, Commercial & Investment Certified, Auctions, Licensed in CT

 

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