What is a Cap Rate and How Does it Affect Real Estate Investments?
The capitalization rate, commonly known as cap rate, is a rate that helps in evaluating a real estate investment.
Not only in real estate, but the Cap Rate is also a measure used in various investment vehicles.
It is calculated as follows:
Cap rate = Net operating income / Current market value (sales price) of the asset
The operating expenses can be property taxes, maintenance costs, etc. Operating expenses however does not include depreciation. Capitalization rate gives the first-hand indicator of the investment worthiness of the asset. However, it is not an exhaustive measure by itself.
By looking at the trend in cap rates in a certain property segment such as single-family homes, if the rates are declining, it means that the market for this sector is gradually heating. Therefore, looking at the historical data on cap rates can instantly let you know where property valuations are headed.
Cap rates can also be used to gauge the direction of the market and also find real estate investments that give a risk-free rate of return and risk premium. A risk-free rate of return is the rate of return on an investment that has no risk of incurring any financial loss.
While capitalization rates can be computed quickly to help you decide whether a particular property is a good buy, there are times when it is irrelevant. This applies to situations when the income from the property is irregular and complex. In this case, you should use a method of valuation known as a full discounted cash flow analysis.