What is Cap Rate?
The capitalization rate, also known as cap rate, is the rate of return that you can expect to get from a real estate investment property. It is one of the most central concepts in the commercial real estate industry, so it’s important to take the time to understand it properly.
The cap rate measures the net operating income (NOI) to the value of the property. If you need a review of how to calculate the NOI, check out our encyclopedia entry about it. The equation reads as follows:
Cap Rate = Net Operating Income/Value.
Interpreting cap rate
The cap rate can be used to determine multiple things, so you have to adjust the formula and your findings to be applicable to what you want to know. One thing to note is the value portion of the formula. Depending on if you are looking to buy or sell, the value can be calculated as being the purchase price or the current market value of the property.
If you are using the cap rate to decide if you should buy a property, use the purchase price as the value in the formula. A higher cap rate is also ideal because it means that your initial investment in the property will be lower. You want your cap rate to be above the interest rate as well because that usually indicates that you will come out ahead on your investment.
If you are using the cap rate to decide if you should sell a property, then use the current market value in the formula. You also want your cap rate to be lower because it indicates that your property value will be higher.
Why is cap rate important for vacation rentals?
The cap gives a good indication of how risky your investment in a property will be. Obviously, you should take other factors into account, but it can help prospective vacation rental owners get an idea of whether they should go ahead and buy a property.
Tracking and analyzing cap rate trends over the years gives an indication of the real estate market as a whole. You can get an idea of if it’s a good time to invest or if you should wait a couple of years. It also allows you to see if a specific area or location you are looking at will be a profitable rental spot.