The cap rate in real estate represents the annual return you expect from your investment, which is driven by the property or asset you happen to be buying and the risk associated with that investment. It is comparable to the yield on a bond along with other return metrics and allows you to do some basic valuation analysis to quickly determine whether an offer may be worth pursuing. What exactly is a Cap Rate?
A Cap Rate is calculated by dividing your property’s Net Operating Income by your property’s Purchase Price or Market Value. It is a percentage that approximates the annual return on the capital required to purchase the property. The higher the cap rate, the riskier the investment because investors want higher returns in return for assuming the higher risk; conversely, the lower the cap rate, the safer the investment. What is a normal cap rate?
There is no set answer to this question as “normal” cap rates fluctuate with the market. Similar to the rate on a bank CD or the yield on a Treasury note, a real estate cap rate is based on what the market will pay for a certain asset dependent upon its risk. The way to determine the market cap rate for a particular real estate asset is to look at comparable deals. Many real estate market data firms and brokers publish data on cap rates in certain sectors.
Every market is different but within a range. For example, an office building in Manhattan will get a lower market cap rate (strong office market: less risk: lower cap rate) as compared to an office building in a less populated and remote city (weak office market: more risk: higher cap rate). Cap rate compression is a term used to mean that cap rates are doing down, and thus properties in that certain sector are becoming more expensive to buy.
To determine if a cap rate is good for a certain deal, we would look at what the market is currently paying for our type of building (ex., office building) in our location by contacting some brokers and asking what the current cap rate is on office buildings in our area. If we determine that the market is valuing office buildings at an 8.0% cap rate, then we would take the net operating income of our building and divide it by “.08″ to determine the market value of our property.
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