Cap rates are confusing for many investors, and for good reason. The theory is simple: A company's net return on its assets is expressed as the percentage of its total asset value that it generates in return from activities such as investing or leasing. However, cap rates are often applied incorrectly or placed in the wrong context. This article provides an overview of cap rates and will help you better understand them so you can use them to your advantage if you're a real estate investor and they pertain to your portfolio.

What is a Cap Rate?

Cap Rate real estate is what determines how much an investor will profit on their investments if they pay back 100% of their property costs over time with current rental income revenue (minus expenses). It describes how much an investor can expect to earn on the investment.

Cap rates are all calculated in the same way: divide the net operating income (NOI) by the value of the asset. Another way to calculate cap rate is to divide NOI by an estimate of a property's value after renovation. However, this calculation will change with each project depending on a variety of factors like geographical location and competition.

Why do Cap Rates Matter?

Cap rates are only important if you're buying properties for cash flow or as investments for cash-out. If you're buying a house for renovation, or if you're investing in an empty land and hoping to fill it with development, then cap rates can be useful. What are some common Cap Rate Mistakes?

The biggest mistake people make is applying investment cap rates to a business. Investing cap rate is different from the operating or net income cap rate. That said, investors often use operating expense/management fee cap rates on earning properties incorrectly. For example, an investor might assume the property management company fee at 20% will knock 10% off the operational net income. That's not the case! You can earn a lot more profit with higher management fees compared to lower ones because your money is working harder at increasing the property's income.

Another common mistake is applying cap rates to a property on the assumption that you will buy and sell it without any repairs. That's not true. Most investors, however, consider cap rates in real estate only when they're buying an investment or long-term rental properties. In this scenario, if the cap rate is low enough, they might assume that if they fix up the place that the property won't lose value. This isn't always true as each property has a different intrinsic value based on how it's used and of course its location in an area with competition for buyers.

Is the Cap Rate Useful for Homeowners?

If you're looking to buy a home for your own use, cap rates are not applicable. When you buy a home, your goal isn't to make money on it. If you're buying a home that's more expensive than what the market is currently paying or what it's valued at, then you need to understand how much the home will cost to maintain and repair over time. The cap rate calculation doesn't work in this scenario.

How to Calculate Cap Rates

There are two ways to calculate the cap rate of real estate, and both are explained below.

Method #1: Operating or Net Income Method

This method is the easier one and is used when calculating cap rates for purchasing investment properties. It's important to note that this calculation takes into account only the operating expenses associated with the property and property management company fees and does not include building maintenance costs. You must also subtract depreciation (building replacement) expenses from earning properties. By calculating this, you can accurately determine what your property will earn after paying for operating costs.

If your property is a house, you can expect it to depreciate 2% each year. So, if your home has a value of $200K and 2% depreciation over the course of a year, then you can deduct $4,000 from its NOI.

Method #2: Replacement Cost Method

This method allows for the calculation of cap rates on development or vacant land properties that aren't yet operational. It's based on a property's potential value after improvements are made. The only difference between this method and the operating income method is that this one calculates the cap rate by dividing net operating income (NOI) by estimated full land value.

Cap Rates for Real Estate Investors

The average cap rate for office and retail properties is 5% to 7%, whereas the average cap rate for industrial properties is around 6%. Residential and apartment properties have the highest cap rates, at between 7% and 9%. These figures represent the property's value divided by the investor's cost to purchase it, or in other words, its net proceeds if it were sold immediately after purchase.

"The cap rate is the most important real estate ratio for investors."

• Anthony Hitt, Real Estate Investor

"From a buyer's perspective, the cap rate is the best ratio to look at when buying commercial properties. When you purchase a property, you are putting your money into it and expecting it to grow and mature over time. A lower cap rate means that your asset will appreciate in value faster."

• Brian Lund, personal finance expert

"Cap rate is an indicator of how fast buildings appreciate in value. It measures the return on investment on a building by dividing the net operating income (NOI) by the cost of development or acquisition. Cap rates are a useful indicator of how quickly an investment will pay for itself. Cap rates generally range between 4% and 12%, depending on the type of property being sold."

• Charles Himmel, real estate investor

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