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What is Cap Rate and How is it Calculated?

Capitalization rate, or cap rate, is an expected rate of return expressed as a percentage. It is useful when analyzing properties at a glance for risk and return, determining expected selling price, and comparing properties.

Calculating Cap Rates

The cap rate is calculated by dividing the net operating income (NOI) of the investment by the purchase price. If you are curious about NOI and the important role it plays in real estate investing, check out this article here. Today we are diving into the different uses for, as well as calculating different numbers using cap rate.

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What is Cap Rate Useful For?

One thing that’s interesting about a cap rate is that it’s an objective number. Given the variables for a property, any investor performing the calculation correctly arrives at the same number.

Cap rate is not factoring in the cost of financing. This means the rate of return you are calculating is before loan costs and the benefits of using leverage.

Why Cap Rate is Different Than Cash on Cash Return

Because of this, the cash on cash return on investments is higher than the cap rate on investments purchased with bank financing.

It’s a great metric to use at first glance when reviewing potential investments, giving you an idea of whether or not a property is worth exploring more closely.

Determining Expected Sales Price

Investors are using cap rates when determining the expected sales price of a property.

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In multifamily real estate, it’s common for a listing not to have a sales price. Requesting historical financials is expected when reaching out to listing agents. Listing brokers providing a trailing 12 (T12) financial statement is normal, and helps in calculating the numbers that are important to know.

Determining “Whisper Price” of a Property Using Cap Rates

Using actual property financials along with modeling out your own proforma, you can arrive at a fairly accurate idea of what the NOI will be.

From here, you can use cap rates of recently closed transactions of similar properties in the area to determine the price range the sellers are expecting offers to fall within. This price range is sometimes called a “whisper price”.

If a property has an NOI of $200,000 and has a 6% cap rate, the sellers are expecting offers of roughly $3.33 million.

Comparing Assets Objectively

The cap rate is indicative of return on investment in a property, which means it is also indicative of risk. In financial theory, risk positively correlates to returns. The higher the risk, the higher the potential return.

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Courtesy of Agent’s Archive

When considering cap rates across investments, the higher cap rate investments are higher risk as well.

The brand new assets that have almost zero risk have lower cap rates, which makes sense. Value add assets that need lots of input and carry more risk also have higher cap rates.

This gives investors an objective metric to use when comparing different investments.

It provides an idea of the risk profile of an investment. Whether its multifamily, storage, industrial, or retail real estate, it provides a lot of info at a glance.

At a Glance

In summary, the capitalization rate (cap rate) is a useful term to know when working with real estate investors. It is crucial to understand when getting into investing yourself as well.

It provides a metric to understand the risk and return profile of an investment when compared to other properties.

Knowing how and where to utilize cap rates when running numbers on properties will get you going in the right direction as you begin your journey working with investor clients.

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Matt Moreland
Matt Morelandhttps://www.mattmorelandrealtor.com/
Matt is a real estate agent, investor, and entrepreneur in Texas, where he lives with his wife and three children. When he is not working on The Agent's Archive, he is helping his clients acquire investment properties, guiding new agents as they enter the industry, farming wine grapes, or working on something for his winery. In his free time he enjoys homesteading with his family, hunting, swimming, and backpacking.