The capitalization rate of a property is the annual return on investment if you would have bought the asset in cash. Cap rates will vary by submarket as well as asset class (A, B, C, etc.) and they only apply to properties with 5 or more units.
Why do cap rates vary?
The cap rate is basically your annual cash return on investment and doesn’t factor in property appreciation. This is why cap rates are higher in bad areas. Investors are willing to take a higher cash return because they know property appreciation will be very little if any at all. The opposite is true for good areas like downtown. Investors know that property appreciation will be high so they are willing to accept a lower cash return.
Cap rate formulas:
(net income) / (asset value) = cap rate.
$100,000 / $1,000,000 = 0.10 or 10%
OR to determine asset value by net income:
(net income) / (cap rate) = value.
$100,000 / 0.10 = $1,000,000
So, the main reason we care about cap rates is because it is a way to determine asset value. Through market research, you can determine what cap rate similar properties have sold for and use that cap rate to place a value on your property.
Using our previous example:
You identified a value add component to this deal because you know the rents at this property are below market. You bought the property for $1,000,000 at a 10 cap so it’s generating 100k in annual net income. By raising the rents to market rates, you were able to increase your net income by $30,000. Now you can determine what your new property value is by taking your new net income and dividing it by your cap rate. (130,000) / (0.10) = $1,300,000.
It gets better.
These days, cap rates for even C class assets are in the 5-6% range and if our previous example was valued at a 5 cap, it would be worth 2.6mm versus 1.3mm.
This is a massive advantage that commercial residential real estate has over single family homes and 1-4 units because those assets are not valued on the income they generate. They are valued specifically by what similar properties have sold for.