What are Capitalization Rates?
Perhaps no topic is more overrated, misunderstood, or debated than cap rate. You could argue that the capitalization rate has more inaccurate or misinformed articles written about it than pretty much any other topic on real estate. So what are capitalization rates?
What are Capitalization Rates?
Investopedia describes capitalization rates (cap rate) as “the rate of return on a real estate investment property based on the expected income of a property. Investors use the capitalization rate to estimate the investor’s potential return on his or her investment.
“The capitalization rates of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property minus all operating costs. Here is the formula for calculating the capitalization rate:
“Capitalization Rates = Net Operating Income / Current Market Value”
There is a relationship between interest rates and cap rates. If interest rates increase, you would expect to pay a higher cap rate for the same income stream. When inflation rises, interest rates rise and the value of your property increases. You must get increased rents or higher NOI enough to keep the cap rate flat.
You can use a cap rate to judge whether a property is over or underpriced compared to similar properties. Take a rental house. If the house is $450,000 and the rent is $1500 per month, the cap rate is 4%. If a similar house is $450,000 and the rent is $1000, the cap rate is 2.7%. On that basis, the second house is more expensive. If you can increase the rent, the cap rate would rise.
Compare
You can also use the cap rate to compare the returns available in various investments. If Bank rates on CDs were 10%, and cap rates were 6%, bank CDs would be a better return with less risk. Today with bank CDs at 1%, even real estate cap rates at 2.6% look good. Cap rates at 10% would be heavenly.
Forbes wrote, “Following the election, interest rates spiked, and buyers began to take a wait-and-see approach before acquiring assets — treading lightly when negotiating deals, though always with cautious optimism about the state of the economy and the market’s response to Trump’s business-friendly agenda.”
Investors are Looking for Low Cap Rates
“In each cycle is, as pricing increases, investors search more widely for potential investments that will meet their return requirements,” Muoio said. “They start in big primary markets, then those get pricier, capitalization rates get compressed [making it] hard to get a good return.”
“I think a lot of investors are coming into the U.S. from Asia and accustomed to lower returns on real estate. They are willing to buy something at a 3% or 4% cap rate,” Harvard Graduate School of Design lecturer Raymond Torto said. “Investors’ expectations in what kind of returns they want are varying because people from other parts of the world are buying real estate. [But investors] accustomed to 6% and 7% returns look at a 4% cap rate and say that’s too expensive.”
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