A cap rate is one type of measurement used in evaluating an investment, indicating risk and the potential rate of return for a prospective property. The annual net operating income of the building divided by its market value, or purchase price, gives you the cap rate.
So, John, our example investor, is looking to purchase a building at, say, $900,000. The building brings in $60,000 in income and incurs $15,000 a year for expenses.
Subtract the annual expenses from the yearly income, and you get the net operating income or NOI. The NOI would then be $45,000 a year in our example. To figure out the cap rate for this building you simply divide the NOI with the purchase price (45,000/900,0000=5%). The cap rate for John’s investment building is 5%.
What does that mean?
John’s investment cap rate of 5% must be considered in relation to other factors affecting the purchase. The higher percentages are viewed as a high-risk investment, bringing in a better return. The lower the rates are, the lower risk is involved, and the less possible profit capability. However, the cap rate of a property may change over time so that lower rates could bring in more profits in the future.
Additionally, a cap rate could mean different things in different situations. Factors that can influence cap rates include: location, interest rates, growth, supply vs. demand, property type, rents that are above or below market, length of the lease term, and financial strength/credit rating of the tenant.
An investor needs to sift through a great deal of information about a building to determine the return on investment it potentially has, but it is still essential to make the wisest decision when investing your hard-earned money.