Article | 10 min read

What Is A Cap Rate In Real Estate?

Written by James Hill
Illustrated by Willow
What Is A Cap Rate In Real Estate?

Willow makes it easy to invest in properties

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Published | Aug. 11, 2022

Cap rates have become very popular as an easy-to-understand metric in a complicated field, but they are often misused. They can negatively affect your investments if they are your primary metric. A cap rate, or capitalization rate, is the relationship between the amount of income a property generates and the cost of the property. The income your property generates is referred to as Net Operating Income (NOI), with the cost being Operating Expenses. If you looked up cap rates right now, you'd find quite a few definitions listing it as a "return" or a "rate of return." While half-true, this is not the complete picture of a cap rate and its relation to commercial real estate investment.

Cap rates, while they affect the yearly return on investment properties, are not a measurement of total return on an investment property. Returns are the change in the price of an investment/asset over time. Cap rates measure property income but do not consider significant factors like leverage and, more importantly, appreciation. When investing in commercial real estate, investors prioritize property appreciation over What Is A Cap Rate In Real Estate? 2 income stream; property appreciation has a much higher ceiling for returns. It also better aligns with the goals and structure of investing in commercial properties; these are longer plays that will pay off over time. If Commercial real estate does not prioritize cash flow, how can most Canadians afford the expensive property, mortgage, property taxes, operational costs, and insurance without having substantial personal wealth?

This is where Willow comes in. Willow provides the average Canadian access to the long-term benefits of investing in commercial real estate properties while negating the barrier of entry and need for immediate positive cash flow, as well as all the work & additional risk that goes along with evaluating and managing a property. All properties acquired by Willow have enormous opportunities for appreciation; our Richmond Road property, for example, has the permits in place that allow it to be rezoned(apartment buildings, condos), and the neighbourhood is also seeing an expansion of Ottawa's LRT system. Both of these are huge signifiers of positive appreciation!

Urban vs Rural

Cap Rates are also a great measure of risk for potential investors. A higher Cap Rate typically means higher risk investment. Comparing rural properties to urban properties demonstrates this. Urban real estate is generally much more expensive than rural, yet rural properties have higher cap rates. Why is Urban real estate so much more appealing to investors?

Urban property sees much more appreciation than rural areas. Urban areas are highly concentrated, have more foot traffic, better transit, better luxuries, more schools, hospitals, and entertainment. When it comes to tenants, urban areas pull from a larger pool of people as they are looking to enjoy those benefits. In the case of vacancy, finding a new, stable tenant in an urban area is far easier than in a rural one.

Context is key! While cap rates can be a quick snapshot of potential return, level of risk, and value of properties, due diligence is still imperative in any investment you make. If property B has a higher cap rate than property A, but property A is about to undergo a renovation and increase its NOI (the result of subtracting operating expenses from a property's operating income, monthly rent, and fees), which is the better investment? This is where location, property types, property class, and tenant credit come into play.

If your potential investment property is valued at $1 million and has a cap rate of 5%, you will earn $50,000 per year in NOI. A higher percent cap rate may mean a higher What Is A Cap Rate In Real Estate? 3 yield, but this does not necessarily mean that it is a better investment than a property with a lower cap rate.

According to Collier's Q2 Cap Rate report on the Current Market, "Despite inflationary and interest rate hike concerns, the national all asset average cap rate continues to edge down."

How do you calculate cap rate?
  • Cap rate calculation is easy once you have the Net Operating Income. To calculate the NOI of a given property, subtract all maintenance costs & operational expenses related to the property, excluding mortgage interest, depreciation, and amortization, from the property's income. The Rate Formula is:

Cap Rate = Net Operating Income/Acquisition Cost or Value of Property

  • For example, if a property's purchase price is $1 million and generates $50 thousand in annual income after deducting expenses, the annual return, or cap rate, is 5%. The $50 thousand in annual income is the Net Operating Income.
Why does it matter so much for real estate investors?

Cap Rates are a great way to communicate the initial yield from a property. It is best used in apples-to-apples comparisons; it's all about the comps! The accessibility of cap rates is an excellent way to communicate value to newer investors, but it can also be misused. Suppose a property has a significantly higher cap rate than its market cap rate. In that case, it may signify an unreliable tenant, the rent may be overpriced, or there's a need for capital expenditures (electric, roof, windows, HVAC, etc.).

Now that we know how to get the cap rate, we can reverse engineer for property value if you have the NOI and cap rate. Property Value = NOI/Cap Rate

If tenant A is paying $3000 in rent for a property you're evaluating, and similar units in the same neighbourhood are paying $2500, you would see the value of the target property go down when tenant A's lease is up. You have to find a new tenant and likely lower the rent, thus reducing your NOI thus lowering the overall value of the property. The property owner may have a particular reason that they can charge this rent, but doing your due diligence allows you to be the judge of the list price.

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Cap Rate vs Cash-on-Cash Return and Internal Rate of Return
  • Cap Rate, Cash-on-cash return, and Internal Rate of Return (IRR) are all methods of evaluating investment properties to varying degrees. Cap rates are the most accessible of the three; almost anybody can do the basic formula in their head. This accessibility also means it provides the most narrow insight into an investment; cap rates do not account for financing costs, taxes (aside from the property taxes), appreciation, capital expenditures, and debt.
  • Cash-on-cash return measures the cash income earned versus the cash invested in a property. If the property purchase was an all-cash investment, then cash-oncash would be the same as the cap rate. The minute leverage comes into play; the two are different.
  • IRR is a metric used in financial analysis to estimate the profitability of potential investments, expressed as an average annual rate of return over the life of the investment. IRR is the lifeblood of commercial real estate investors as it measures the yield of a property over a holding period rather than the rental income against investment. If cap rates are a thermometer, IRRs are a weather radar. If cap rates are a snapshot, IRRs are a long-exposure panorama!
"A Cap Rate is a simple form of a risk/return, and at Willow, we use it as one part of measuring the attractiveness of an investment." - Kevin Huynh, Willow CIO.

Before you dive into Real Estate Investing, make sure you look at more than cap rates. While it's an important figure to differentiate like properties, investment opportunities do not live or die by it. You don't need to be an expert in investing in commercial real estate. Just make sure that you do your research. Or, even better, you can let Willow do the research for you and buy a piece of property today!




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