Cap Rate – What Is It and Why Is It Important to Me as a Buyer?

After weeks of searching, walking under the sun, and viewing properties, you finally found one property that would be perfect for you. It is in the right neighborhood, has the right number of bedrooms, and the price seems very reasonable. You think to yourself, “this is going to be a great investment.” But… is it really?

Many people believe that buying a home is a good investment, as historically, real estate values rise. That statement, however, is not 100% accurate. The truth is, average home values have only appreciated slightly when adjusted to inflation in the past 100 years. Therefore, as a smart buyer who makes strategic investment decisions, you must look at other metrics, and the cap rate is one of them.
 
 

What Is “Cap Rate”?

 
The capitalization rate, commonly referred to as the “cap rate”, is a rate real estate professionals and investors use to evaluate a real estate investment. Widely adopted in the commercial real estate sector, the cap rate is calculated as follows:

Cap Rate = Net Operating Income (NOI) / Property Asset Value

For those who are unfamiliar with the commercial real estate, net operating income refers to the income generated by real estate properties less expenses as well as vacancies. Many people adopt the same concept when investing in residential properties by taking into account the potential rental income. So, for instance, if you plan to purchase a condo unit and later rent it out, the annual rental income less vacancies and expenses (such as maintenance, real estate taxes, condo fees, etc.) will be the NOI of your property. Since each property has different NOI and asset value, it goes without saying that each property has a different cap rate, and cap rates also vary across different asset classes and real estate markets.

The tables below further illustrate how cap rates are affected by NOI and asset value.

When asset value is the same:

NOI 4,000 5,000 6,000 7,000 8,000
Asset Value 100,000 100,000 100,000 100,000 100,000
Cap Rate 4% 5% 6% 7% 8%
When NOI remains constant:

NOI 5,000 5,000 5,000 5,000 5,000
Asset Value 80,000 90,000 100,000 110,000 120,000
Cap Rate 6.25% 5.56% 5.00% 4.54% 4.17%

Additionally, the cap rate is a measure of risk. Remember, nothing is riskless – whether you invest in bonds, stocks, or real estate properties. As a smart buyer, in addition to taking into account the expenses and potential income, you also have to think about risk, and luckily, the cap rate can point you in the right direction. To better understand cap rates as a measure of risk, let us first take a look at the equation below:

Cap Rate = Risk-Free Rate + Risk Premium

The risk-free rate of return represents the interest you can expect from a risk-free investment over a period of time. The risk premium represents the interest you expect to get by tolerating the extra risk when investing in a risky asset. In our case, the risky asset is a real estate property. While you might think that investing in real estate is less risky than investing in the stock market, there is always risk involved, such as the age of the property, supply and demand in the market, and liquidity.

To further illustrate how cap rates reflect the risk premium, let us look at a very basic example. Below are two properties in the Upper West Side, New York City:

138 W 87th Street 609 Columbus Circle
Built in 1910 1971
Estimated Rent $4,200/month $3,300/month
Asking Price $595,000 $575,000
Cap Rate 6.76% 5.67%

Assuming that the risk-free rate is 2%, building #1 carries a risk premium of 4.76%, and the risk premium for building #2 is 3.67%. The 1% difference reflects the risk you would have to take on if you purchase the older building – building #1. The risk might be higher maintenance expenses or difficulties of finding the right tenant given the age of the property.
 

Why Is It Important to Me as A Buyer?

 
Home prices are on the rise and buying nowadays means more than just owning a home. For you to move your money from your pocket or your bank, you need something to help you justify the cause. Whether you are planning to buy your first home or are looking to diversify your investment portfolio, the potential return is key, and the cap rate certainly provides some insights.

But how is the cap rate useful for you as a buyer? As mentioned earlier, the cap rate of a property is determined by its value and net operating income, and so a property with a higher cap rate usually means

  • It has the potential to generate higher income; or
  • It is a good deal as the asking price is lower.

For instance, two properties have the same asking price of $100,000. Property A has a cap rate of 5%, and property B has a cap rate of 7%. Using the first equation we introduced earlier, the NOI of property A is $5,000, and for property B, it is $7,000. Which one, then, should you buy?

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The cap rate is one of the key metrics to look at when it comes to investing in real estate properties, which is why on RealtyHop, you see most properties are listed with cap rates, and the data is backed by years of rental data we have collected from our sister site, RentHop. Of course, the cap rate is not the only factor. For you to make the right investment decisions, you also have to look at other components, such as market rent trends, interest rates, and local, national, as well as global economic growth. Be sure to check out market reports, interest rates, new developments in your target neighborhood, and overall economic growth before making a move.