Cap rate, short for capitalization rate, is an industry term that measures the Net Operating Income in proportion to the price of the asset.
Let me give you an example of that to make this easier to understand:
Let’s say you’re looking to invest in a property with the following metrics:
- Net Operating Income: $100,000
- Price: $2,000,000
The way you would calculate the cap rate is by taking $100,000 and dividing it by the price of $2,000,000, giving you a cap rate at purchase of 5%.
What is considered a good Cap Rate in Real Estate?
Just as with anything, cap rates are one aspect real estate investors should look at, but it certainly shouldn’t be the only metric. A general rule of thumb is the higher the cap rate, the less demand there is for an asset and the lower upside potential.
Lower cap rates tend to happen with deals that have more demand and more upside potential.
How does that work?
Good question. Let’s assume you see two deals. One deal at 10% cap rate, and the other at 5% cap rate. Which deal should you choose to invest in?
The answer is, it depends. That’s not enough information. Let’s dig further:
The 10% cap rate may be in a low demand market that has high vacancy rates, less demand, little to no population growth, etc.
On the other hand, the 5% cap rate deal may be in a very well established market, with lots of demand, appreciation, rent growth, and more back end upside potential.
I’d go with the second option all day long. We prefer higher quality assets in higher quality locations that reduce the risk profile of deals we invest in. Cap rates are just the tip of the iceberg and should not be the sole determining factor of whether a deal is good or bad. It’s also important to note that if the property happens to be in a slow growing market, cap rates may stay high when you’re ready to resell, which would cause you to sell at a low valuation just as when you bought the property. On the other hand, if you are investing in a market where cap rates are continuously going down as valuations go up, you might buy at a certain cap rate and end up selling at an even lower cap rate, causing you to make money off of appreciation. You generally never want to expect cap rates to go down, as that is not controlled by you, instead, it’s always safer to assume that cap rates are going up, meaning you are modeling in a market slow down, so that if the market performs better than expected, you’d end up with a bigger upside, while also limiting your downside by not being too aggressive with your future projections.
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