Capitalization Rates in Real Estate

Capitalization rates in real estate are used to determine the purchase price of real estate investment property. They are a common tool used by real estate investors to get an initial grasp on the performance of the property and to understand what it will cost to buy in to an income stream. Capitalization rates are also commonly referred to as the property’s “cap rate” or simply “cap”. While a property’s capitalization rate isn’t the sole determining factor when analyzing an investment for purchase, it is important and should be researched and weighted heavily before acquisition.

The formula for determining a property’s capitalization rate is a simple equation:

Net Operating Income/Purchase Price = Capitalization Rate

For example: Assume an investor purchases a real estate investment property for $100,000 and it has a net operating income of $10,000. The investor is purchasing the property at a 10 percent capitalization rate.

How do investors determine an acceptable cap rate for their investment? Three factors that help to determine this are the market, the investment strategy and the type of the property. The higher the cap rate, the less an investor is willing to pay for the income stream.

Items that typically justify a lower capitalization rate:

• Strong, stable markets (major metropolitan areas)
• A high-end property in an excellent location (oftentimes called a “trophy property”)
• Financially strong long-term tenants for office/industrial space
• Extremely low or zero vacancy for Class A multifamily space

Items that typically justify a higher cap rate:

• Smaller, weaker markets (tertiary markets)
• Older properties and properties with deferred maintenance
• Less than creditworthy tenants for office/industrial space
• Multifamily properties with vacancies above the industry standard (expected to be 4.8 percent in 2015 according to Freddie Mac)

Because cap rates are typically one of the first financial factors to be analyzed when considering a property for investment, the vetting of the property’s net operating income is extremely important. If the income is inflated, it can result in overpayment for the property when comparing properties with similar cap rates.

When determining if a real estate investment property is right for you, call Black Diamond Realty. We can help by showing you the current going in cap rates in the market and assist you in evaluating a purchase. Call Ryan at 304-413-4350.