## Understanding the CAP Rate

#### Updated on July 29, 2020

When analyzing a commercial real estate investment property, one of the core formulas used to understand whether you have a good deal or not is the Capitalization Rate or CAP rate. This will give you a snapshot of the rate of return for a period of time.

In previous posts, I’ve discussed NOI or Net Operating Income. In case you missed it, your net operating income is the amount of income a property is throwing off after all expenses like taxes, insurance, utilities, and maintenance, but before debt service.

Once you have a handle on the properties NOI, you need to find out the purchase or asking price of the property. Remember, there is a direct correlation between the value of a building and its current NOI. With that said, it is incredibly important that you understand a property’s net operating income. If the annual income that you are plugging into your cap rate formula is incorrect, your cap rate calculation on the rental property will be incorrect. As we say, garbage in, garbage out.

Once you know the asking price of a property, you can divide your current NOI by the purchase price, and come up with your capitalization rate (cap rate).

### Here’s an example:

Current NOI = \$500,000

500,000/6,000,000 = 8.33%

This property is offered at an 8.33 Cap.

What a property cap rate allows you to do is compare it to other similar assets trading in the marketplace. For instance, if you had two identical office buildings with identical tenants sitting right next to each other, and one was offered at a 10 Cap and the other an 8.3 Cap, the 10 Cap is probably the better buy. Not always though! A higher cap rate should not fool real estate investors. You need to look at a deal from all angles. Cash flow is king, but a property offered at a higher cap rate may have some underlying issues that may make a good cap rate turn into a lower cap rate and a bad IRR over the life of the investment. You can learn about the cap rate vs IRR here.

### What Is An Average Cap Rate?

Gone are the days of the 10 cap and 12 cap. Real estate investing in the current real estate market will deliver anywhere from 4-7% returns. We generally find exceptional deals with great market value, but 4-7% is the general average for a commercial property.

### Use Cap Rate To Assess Risk

Cap rate is a way to estimate risk. Higher cap rate usually means return on investment will be at a higher level of risk. A lower cap rate conversely can mean a lower level of risk.

So, is it better to go for a lower risk investment (lower cap rate) or a higher risk investment (higher cap rate) that might have a better potential for a higher return on investment? With most investment decisions, the answer isn’t plain and simple, it depends on your personal needs for investment opportunities at any given time.

Keep in mind, cap rate is not the holy grail metric when it comes to evaluating deals. It is just one component that tells you the current situation of an asset being offered for sale.