What Does Cap Rate Mean In Real Estate?

When making a real estate investment, it’s essential to understand the concept of a “cap rate.” It can help investors decide how much more money they should put into a property, making it a helpful tool when looking at real estate investment opportunities.

Cap rates differ for various property types, and understanding the factors that affect them will help you make wise investment decisions. 

Let’s look at the meaning of the real estate cap rate and the factors affecting it. 

What Is the Cap Rate?

Also known as the “capitalization rate” refers to the relationship between a property’s net income and its current market value. It is typically expressed as a percentage, and the formula simply divides the property’s net operating income (NOI) by its current market value. 

In other words, it measures how much income an investment property generates relative to its purchase price. 

The higher the cap rate, the higher the return on investment. For example, let’s say you buy a property for $1 million that generates $100,000 in annual NOI. That property has a cap rate of 10%. If you buy another property for $2 million that also generates $100,000 in annual NOI, that property has a cap rate of 5%. 

While the second property costs twice as much as the first, it generates half the returns. As an investor, you want to aim for properties with high cap rates to maximize your investment return. 

Many factors can affect the calculation and overall profitability of a property. However, cap rates can be a helpful tool for comparing different investment opportunities or determining the valuation of a property based on its income potential. 

What Factors Affect A Property’s Cap Rate?

Several factors can affect a property’s cap rate. Some of these factors are within your control as an investor, while others are out of your control and simply reflect prevailing market conditions. 

Controllable Factors 

Purchase Price: Obviously, the lower the purchase price, the higher the return will be—all other things being equal.

Operating Expenses: The lower your operating expenses, the higher your NOI and your return on investment. Therefore, it pays to be vigilant about controlling costs such as insurance, landscaping, repairs, maintenance, etc. 

Leasing Income: The more money you can generate from leasing income, the higher your NOI and ROI will be. It’s essential to carefully consider things like lease terms and rent prices when contemplating an investment property purchase. 

Location: The location and condition of the property also play a role, as these factors can impact both rental demand and the potential for future appreciation. For example, commercial properties located in a high-traffic metropolis are more likely to have a high cap rate than one in a deteriorating town. 

Additional Capital: Your own capital investments drive a property’s cap rate. If you inject added capital to renovate a property, it will drive the market value by commanding higher rental rates and increasing your operating income. 

Uncontrollable Factors 

Interest Rates: Rising interest rates can compress cap rates because they increase the cost of debt financing and make alternative investments more attractive relative to real estate. Conversely, falling interest rates have the opposite effect and tend to push up prices and compress cap rates. 

Economic Conditions: Generally, solid economic conditions increase demand for commercial real estate space, pushing up prices and compressing cap rates. Weak economic conditions have the opposite effect and tend to reduce prices and expand cap rates. 

However, there are exceptions to this general rule—for example, some types of properties (such as warehouses) may actually do better in weak economic conditions because they benefit from increased activity in sectors such as e-commerce/fulfillment during periods of slower growth. 

The stability and growth potential of the local economy is another factor to consider, as it can affect rental rates and the area’s desirability for tenants or buyers. A well-developed area that faces a lot of competition will have properties with lower capitalization rates due to competitive pressures.  

Market Conditions: Cap rates can also be affected by specific market conditions, such as changes in zoning regulations or new construction coming online in a particular submarket or micro-market, affecting supply and demand dynamics. 

Ultimately, considering all of these factors can help accurately determine a property’s cap rate and overall value.

What Is A Good Cap Rate?

The average cap rate for U.S. real estate is around 7%. Hotels have the highest cap rate at 11%, followed by self-storage properties at 10%. Industrial real estate and commercial real estate also enjoy higher-than-average cap rates, at 9% and 8%, respectively. Enjoy high-cap-rate investment properties through real estate funds that invest in professionally-vetted rental properties offering a secure and dependable income stream. Saint Investments gives you access to these high-return investment vehicles. Get in touch for a free consultation to learn how.