A Guide to Real Estate Cap Rates
There are several figures and statistics that one might need to pore over to understand cap rate.
01/06/2020
For many of us, real estate with its terms and jargons remains an elusive topic. And it is not just for people who have no business with this massive sphere. The same holds true even for people who wade through this nebulous domain day in and day out. Understanding all that is there to real estate might take a few lifetimes. But we have got only one, and we need to make sure that we grasp the concepts that are the most important. One such important concept that concerns real estate is the cap rate, or capitalization rate. There are several figures and statistics that one might need to pore over to understand cap rate; or if you want a more comprehensive and easy way to understand what real estate cap rates are, read through this article to be enlightened.
Real Estate Capitalization Rate:
To provide a working definition of the capitalization rate, it is an indicator of the rate of return that is supposed to be generated on a real estate property investment. You cannot just wake up one day thinking that now is a fine tie to invest in a real estate property. You need to gauge all sides factor in several costs related to the property and only then can you hope to make a fruitful investment. The capitalization rate is calculated by determining the property’s net operating income and dividing the same by its current market value. However, you must be careful about the fact that this ratio that is expressed as a percentage cannot truly indicate the value of similar real estate properties. Each property is subjective and has its own costs to consider.
More Insight into the Cap Rate:
To understand the cap rate in greater details, we shall provide you with some more insight into the same. The cap rate is essentially a yardstick to measure a property’s value and how it could benefit the investor over a period of time. And there is a formula that can be used to determine this value. Several variations of the formula exist, and people use it in different ways, but we are going to discuss the one that looks like the standard.
The Capitalization Rate can be obtained by dividing the property’s Net Operating Income (NOI) by the Current Market Value. The Net Operating Income is the annual income of the property minus all the additional costs required to maintain the property, like property taxes, maintenance and the like. The Current Market Value of the property, as can be understood by the term itself, is the value at which the property can be priced in the prevailing market scenario by factoring in all the costs. You can also refer to Gowercrowd Cap Rates for more reference to the capitalization rates.
How Do You Interpret the Capitalization Rate?
Cap rates determine how a real estate property shall turn out in the future, which is why it is also quite likely to vary. Therefore, it is important that you know how to interpret the rate without giving in to biases or illogical calculations. There are several elements to factor in while analyzing and interpreting a cap rate. For instance, you need to take in the duration of time a property will take to give the returns. You must also factor in the difference in time horizons on the same property. The risks associated with the investment on a property shall differ with the horizons of time. Normally, the cap rate tends to be higher for properties generating a high net operating income and a low valuation.
There is also the factor of location that needs to be taken in while interpreting the cap rate. Here is an example that can help you understand this better. For instance, if there are two very similar properties in two different locations, the cap rates will be significantly different. The property that is situated within the city shall have a lower cap and therefore, a higher market valuation than the one that is situated on the outskirts of the city. Of course, there are several other technicalities that you need to consider when you are working through the figures in real-time. This example only serves well in a hypothetical situation like this one. But the reality is a bit different. And if you are a real estate agent yourself, you need to keep in mind how these figures vary in real-time.
The Gordon Model Representation:
Another significant model that can be followed for real estate cap rate is the Gordon model representation which is usually used to calculate the value of a company’s stock without factoring in the current market conditions. To put it into more mathematical terms, the stock value of the company can be obtained by dividing the Expected Annual Dividend Cash Flow by the difference between the investor’s required rate of return and the expected dividend growth rate. However, you can also use it to calculate the value of a real estate property. The only thing that you must do is substitute the expected cash flow with the net operating costs. That shall give you a holistic insight into the market value of your property. However, if this mathematical formula looks too dense to work your way through, you can always use the one that we have thoroughly described in the earlier sections.
Conclusion:
The real estate is a volatile area, and more so because there is no one formula that can predict the future appropriately. It is always a matter of chance that runs the domain of real estate. Therefore, it is important that you pay attention to the details around you and only then analyze the elements that make up the formula of the cap rate. Real estate is vulnerable and impregnated with risks, and it is probably not possible to eradicate the risks in their entirety. But, a little awareness and knowledge can go a long way in making informed decisions and minimize the chances of running losses.