Cap Rate: What is it and Why is it Relevant?

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Birgo

Cap rate, a term frequently used in real estate, demonstrates the return on one’s investment in a property, usually a commercial building. It is defined as annual operating net income divided by the cost of the property. What needs to be noted for financing purposes, and could easily be forgotten by some people, is that debt on the property is not taken into account for. Also, it needs to be understood by potential investors that cap rate is not the same as the cash flow.

Cap Rate and Investing

Cap rates vary by city and property, allowing potential investors to classify properties in such a way to group together similar properties. One use is found in examining current trends. Trends are important in real estate as they can give indications of what directions investments could be headed. The investors and property owners involved could know if it is the time to buy or sell more property. Or, if someone is looking to develop a property, knowing the common cap rate of the area is helpful to budgeting returns.  When addressing whether an investment is worthwhile, the cap rate is one of many factors that go into the answer.

Changes by Location

Cap rate acts as a measurement of risk. The bigger the cap rate, the bigger the risk, and vice versa. If someone wishes to invest in real estate, a cap rate is a tangible way to compare a few different properties. Two or more different properties can be compared with each other from a more practical standpoint where the vastly different miscellaneous costs are not taken into account.

Changes by Location

Cap rate branches out into many different fields. A prime aspect of this is the concept of location. For example, a property in New York City is more likely to be worth more than a property in a very small town in the Midwest, as there is a different cost of living in both cities. Factored into the costs of living there are vastly different local economies, employment rates, and levels of education. These are leading factors for why there is essentially a tiered system of cap rates.

What Makes a Cap Rate Attractive?

At the end of the day, what makes a cap rate attractive largely depends on the needs of the investors involved. What one individual defines as a “good” cap rate may be entirely out of another’s budget. Cap rate is situational, and knowing personal goals and the market at hand is crucial.

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