Capitalization rate or more commonly referred to as a cap rate, is a great investment tool for real estate investors when it comes to assessing their potential investment profitability as well as the risk involved. A cap rate shows the rate of return that the property is expected to produce. It can also be used to measure the risk of investment, with the higher the cap rate, the riskier the potential investment is. It’s important to keep in mind that there really is no “good” cap rate. What is considered good is up to that investor, but looking at the cap rate for a property can help give a bigger picture to what that investment has to offer.
There are two different ways to calculate the cap rate of a real estate investment. The first way to calculate the cap rate is dividing the NOI by the market value of the property. This is generally the most popular way to calculate the cap rate as it gives the most accurate representation when comparing the investment to the market. The other way of calculating the cap rate is dividing the NOI by the purchase price of the property. This is generally less popular as it doesn’t give as accurate of a representation due the value of a property fluctuating. By using the market value of the property, this takes into account the fluctuation of the value compared to using the purchase price which uses a fixed value and may be outdated compared to the current market.
Using the cap rate.
Once you’ve gone ahead and calculated the cap rate for your investment, now it is time to analyze and interpret what it means. It is important to note that like any other financial ratio, the cap rate alone shouldn’t be solely looked at and there is generally no exact number that everyone looks for. What is considered a good cap rate will change depending on the market that you are comparing it to and the investor undertaking the risk. The thing to note about cap rates is the higher the rate, the higher the risk and the lower the rate the lower the risk. By keeping this in mind, the cap rate can be used to measure the levels of risk in that particular investment compared to either another investment or either a whole market. Whether a higher or lower cap rate is better will be up your interpretation as an investor and what kind of strategy you are using for that particular investment. A cap rate can allow an investor to compare and analyze different markets and property types, giving them an understanding of what’s more profitable and risk level. With this, they can then look to get a deeper understanding of these markets and look to make decisions to profit from their research. Essentially, a cap rate is a tool an investor can use in an attempt to get the bigger picture and make smart investing decisions. Overall, a cap rate can be used to analyze and compare investments and looking at the overall market to get a bigger picture of what is happens or trends that may be occurring.
The cap rate for a real estate property can be a great tool to balance the risk and profitability of the property you are buying in to. Using it to compare with other properties or the market is a great way to understand what type of investment you are undertaking and risks associated. Two things to keep in mind is that the cap rate should not be the only measure for an investment and there’s not really a good or bad cap rate, this will all be relative to the individual investor and the market at the time. However, with some market research and understanding what your strategy is with your investment, using the cap rate in your financial analysis can be a great tool in measuring the risk versus reward of investment.