Understanding Cap Rate
Written by Albert J. Haddad
How the Cap Rate will Affect the Real Estate Investor
No one goes into an investment opportunity without understanding what can possibly affect an investment. During my conversations with people our attention rightly focuses on the best approach to their investment while factoring in what will impact the value of their return.
When it comes to commercial real estate, the number one thing that will determine the value of your investment is the capitalization rate—or cap rate, as it measures the potential annual rate of return on a property.
Cap rate is a relatively simple formula. Essentially it is understood by taking the Net Operating Income (NOI)—income made on the property — and dividing it by the current property price or marketed and perceived current market value. Check out the formula below:
Cap Rate = NOI / Current Market Price Valuation
What investors need to see is how their current property is being affected by the current economic market trends. If an investor buys a property for $1 million, and their property’s NOI for year one is $70,000, their cap rate will be 7% ($70,000 [NOI] / $1 million [Current Market Price Valuation] = 7% Cap Rate).
With the Fed having cut rates three times in 2019, it is actually a good yet cautious sign for investors because pausing or freezing interest rates directly affects cap rate.
When it comes to investing, the lower your capitalization rate, the higher the valuation on your property. This can be good for sellers and dangerous for buyers—especially if you are borrowing the money to invest.
The question we need to be asking ourselves is: what’s the best way to see cap rate in an investment setting? The best way to see a cap rate is with a stabilized growth, as opposed to mountains and valleys on reports. In fact, mountains and valleys can be tenuous in any investment.
The decision by the Federal Reserve to seemingly pause interest rate hikes is an attempt at stabilization. The goal is to make sure that your property maintains its value, which is difficult with a volatile market. By stabilizing the market, cap rates in turn should stabilize and bend the spectrum back toward the middle instead of favoring sellers versus buyers.
Taking into account the capitalization rate of an investment property should be the modus operandi for any investor. Knowing, up front, the type of return you can get on your investment will make you an informed decision maker.
If you have any questions about cap rates and how they can affect you, please call the Alpha-Rex team to discuss and answer questions on any property or portfolio needs you have.
