The real estate market can often come across as a black box of investing. Especially after the subprime mortgage crisis of 2007-2010, there has been a persisting level of wariness as it relates to real estate. Since that recession, real estate values have been on the rise, especially in metropolitan areas. One of the easiest tools to quickly evaluate and quantify return on investment (ROI) potential within the real estate sphere is to measure the capitalization rate, or cap rate. With the help of our friends at Short Term Rentals NYC, a short term rental agency, we help you break down capitalization rates, and how they work.

Capitalization Rate Defined

A cap rate is calculated based on the ratio between net operating income (NOI) and property asset value (the market value of buying or selling the property). To break it down even further, NOI is the value of the net rental rate, or operating expenses subtracted from actual income.

A quick simplification of this:

Capitalization Rate: Net Operating Income (NOI) Divided by Market Value of the Property

For example, you are an investor looking to purchase a building. The property of interest has an NOI of $120,000 and is being sold at an asking price of $1,600,000. Using the formula and dividing $120,000/$1,600,000 will yield a cap rate of 7.5%. As an investor, this translates to a 7.5% ROI for you.

Utilizing the Capitalization Rate

The basic function of a cap rate is to measure the potential ROI on any given real estate investment. It represents the risk associated with an investment: The higher the cap rate, the higher the risk, but also the higher the potential ROI. Inversely, a lower cap rate is indicative of lower investment risk, but accompanies a lower payout.

In order to quantify this risk premium, you can compare a cap rate to U.S. Treasury bonds, which are the basis of a risk-free investment. By subtracting the yield rate of these bonds from the cap rate, it reveals the risk premium associated with the investment. For example, if U.S. bonds are yielding at 4%, and a real estate property’s cap rate is 8%, the risk premium value is 4%. For a risk-averse person, this amount may not appear worth it for the chance of an 4% greater ROI than the steady payout from the bonds. However, for others, this is well worth the potential instability that arises from engaging in the market.

Cap rates also serve a predictive function. In one sense, investors are able to compare similar properties (location, price, etc.) and use the cap rate to differentiate between them in terms of higher-risk investments. If one building in a similar location with similar amenities has a much higher cap rate than another, an investor will wonder what the risk factors are associated with it that contribute to such a gap in the cap rate.

As a market forecasting tool, cap rates can be used to predict future value fluctuations. Given that cap rates decrease as property values increase, historical cap data can be referred to as an indicator of expected valuation trends.

Capitalization Rates In Practice

One way to understand cap rates is to take a historical perspective. Observe their fluctuations in accordance with real estate recessions and surges. In general, the lower the cap rate, the less risk associated with the property and the higher its market value. How it’s often interpreted at the higher level: The lower the cap rate, the healthier the real estate market, given that, this means property values are higher.

During the Great Recession previously mentioned from 2007-2010, home values were at an all-time low. Cap rates reflected this inversely: At the start of the recession, before the full impact was felt, capitalization rates for commercial properties were at a low of 6.73%. By the end of 2009, however, they had jumped to an average of 8.46%.

Though the real estate market has considerably improved since this time, the average retail cap rate as of Q4 2016 was 8.1%, indicating there is still considerable risk involved with this type of venture. Meanwhile, apartment cap rates averaged out at 5.8% at the end of Q4, 2016. This trend portrays the larger tendency for urban real estate investment to be far less risky than retail.

Even within the same market (commercial versus residential), there can be vast differentiation of cap rates based on perceived risks. For example, for a Class A commercial property in a central business district (CBD), the cap rate in Los Angeles was under 5%.  In Memphis it was almost 9%. The reason behind this is that the perceived operational and valuation risks in Memphis far exceed those in Los Angeles. However, for a risk-taking investor, Memphis can represent a huge ROI potential as a developing, vibrant metropolitan hub.

When Not to Use Cap Rates

Capitalization rates fulfill the basic calculation of ROI and serve some predictive function.  Although they cannot account for more complex cash flow processes. A cap rate should be used for quick valuations and to understand the real estate market fluctuations on a high level. For deeper understandings and to account for all variations of cash flow systems, you should conduct a comprehensive analysis.