What Are Cap Rates, and Why Are They Important When Analyzing Real Estate Investments?

There are many steps an investor must take to determine whether a real estate investment is sound. To do this, the savvy investor will conduct numerous analyses. One of the most important metrics the investor has in their arsenal when analyzing potential investment is the capitalization rate.  

What is a capitalization rate is and why is it instrumental in analyzing real estate investments? The cap rate represents the rate of return one can expect to receive on an investment. It’s important because it’s an excellent tool for measuring risk. The capitalization rate, or cap rate for short, is mainly used in commercial, residential, or multifamily investments. One of my favorite websites, Investopedia, has a great article on capitalization rates that can be found here.

How do we compute it? Fortunately, it is relatively easy to calculate, assuming an investor has accurate information.  The aspiring investor needs only to divide the net operating income by the asset’s value. The equation is simple, but determining an accurate pro forma net operating income may prove difficult. Real estate agents representing investors or experienced investors should evaluate a pro forma net operating income and property value. However, it’s important to remember that the aspiring investor will only have power over how much they pay for the asset as the market determines the net operating income. For example, if a property generates an estimated $10,000 a year and is acquired for $150,000, then the cap rate is 6.67%; however, if the investor can purchase the same property at $130,000, then the cap rate is over 100 basis points higher at 7.69%! That said, the cap rate should not be the only metric an investor uses to analyze an investment property.

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