By James M. Maloney
Genesis Real Estate and Development, Inc.
Are you an investor looking to buy an income generating property? Are you a business owner looking to sell your company? Understanding CAP Rates is a fundamental tool that you should be aware of.
Many real estate investors determine the value of an income property by using the Capitalization rate, other wise known as CAP Rate. Wikipedia’s official definition is “The ratio between the net operating income produced by an asset and it’s capital cost (the original price paid to buy the asset or alternatively its current market value)”.
The rate is calculated in a simple fashions follows:
Cap rate = annual net operating income/cost (or value)
To determine net operating income, you would need to take the total gross lease income during one year and subtract all fixed and variable costs. CAP rates are really an indirect measure of how fast an investment will pay for itself.
To better understand how CAP Rates have changed and why they are important, take a recent Wall Street Journal report that showed from 2001 to end of 2007, the cap rate for offices dropped from about 10% to 5.5%, and for apartments from about 8.5% to 6%. At the peak of the real estate bubble in 2006 and 2007, some deals were done at even lower rates. We also witnessed this across the White Mountains where CAP Rates hit historic lows during these times.
Since 2007, the trend of low CAP Rates has reversed as real estate prices have declined faster than rents. This means that CAP Rates have returned to higher levels on everything from Apartments to Medical Office Space.