What Is a Cap Rate and How Do You Calculate It?
The capitalization rate, also known as Cap Rate, is mostly used in commercial real estate to indicate the rate of return, but it can also measure the level of risk that a commercial real estate property carries. And we all know that risks are always involved when it comes to real estate investments. It’s basically a mathematical formula used to calculate the ROI (Rate of Return) you’d expect to receive from a property you plan to purchase.
Calculation Example: If the current market value of a property is $1 million and has an NOI (Net Operating Income) of $70,000, then the cap rate is 7% or 1,000,000 ÷ 70,000 = 7.
Now what does the calculation actually mean? It generally means the lower the cap rate, the lower your risk. Different cap rates between properties represent different levels of risk. Each asset type typically trades within its own cap rate range. That’s right!
- A multi-talented stabilized retail might trade between 6-9%
- A stabilized multifamily will trade anywhere between a 4-6% cap rate
Multifamily assets consistently have among the lowest cap rates within a market, because they are considered to provide lower risk compared to other asset types.
When analyzing a potential investment property to determine the right cap rate, you should consider several factors such as location, asset type, and the current interest rate.
As an investor, the challenge is to determine the right cap rate given the riskiness of the deal. So now you know what a Cap Rate is and how to calculate it, are you going to use it?
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Adam Dickert is a partner at Progress Realty Partners and is responsible for identifying and analyzing commercial real estate investments for acquisition. Progress Realty Partners has worked with passive investors to generate consistent returns through ownership of real estate.