Capitalization rate, or cap rate for short, is a measurement used by all real estate investors, whether they are commercial or residential investors. It shows them the potential rate of return on a property. Knowing the cap rate is advantageous in deciding whether or not a property is worth investing in or purchasing.
In this article, we wanted to go deeper into everything you need to know about the cap rate and what a good one is.
How the Cap Rate Works and Why It Matters
The cap rate is a formula, and a very simple one as well:
Cap rate = net operating income / current property value
The rate is based on a one-year period, and this simple measurement is usually enough for most investors to determine how valuable a property is.
Naturally, something so simple can’t always be enough for determining the value of a building. For that reason, we highly advise you to use the cap rate together with a few other evaluation tools. By doing that, you can get a more clear picture of how valuable a property truly is.
We advise this because the cap rate is based on annual returns, which can’t always reflect the actual value of a property. Sometimes they only have a single good year, and you can end up investing in a property without the full picture. Plus, cap rates don’t take into account things like mortgage payments, lender fees, closing costs, and more.
Despite its flaws, the cap rate is still an essential part of determining the value of a property. A long-term investor should always look into the cap rate of a residential or commercial property. On the other hand, those looking to flip the property quickly need not rely on it at all as they won’t be renting it.
Cap rates matter mostly because:
- A rising cap rate shows that there is a rise in the income of the property relative to its price
- A falling cap rate indicates that the income of a property is lower compared to its price.
What Is a Good Cap Rate?
Now that we’ve covered everything important you need to know, we can give you an adequate answer to this vital question.
A good cap rate is usually very subjective, but many investors tend to agree that it is somewhere between 4% and 12%. In high-demand areas like Southern California and New York, a 4% cap rate is usually the norm. In less demanding cities and rural neighborhoods, it’s usually well above that. Just remember, generally speaking, the higher the return the higher the risk associated with the investment.
Naturally, it always depends on how you’re using the cap rate, but this answer should satisfy most investors not looking to delve too deep into cap rates.
If you do want to delve deeper, you need to consider the amount of risk you are willing to take, as cap rates are proportional to the amount of risk involved. The lower the cap rate, the lower the risk, and the higher the cap rate, the higher the risk. So, when you start to think about what a reasonable cap rate is for you, it’s necessary to determine how much risk you are willing to accept. By determining that, you’ll know precisely what cap rate will be suitable for you.