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Cap Rate

Definition1

Net Operating Income / Purchase Price Where Net Operating Income: Gross Rental Income - Vacnancy/Credit Loss Reserve - Property Taxes - Property Insurance - Maintenance/Repairs - Common Utilities (if any) - Other Expenses (ex: license/HOA)

Interpretation

  • Cap Rate formula does not include mortgage expenses. This formula focuses on the property alone, and assumes the property is bought for cash w/o leverage.
  • High cap rate means the investment is more risky, low cap rate means an investment is less risky

Drives

Macro-level economics and demographics

  • Positively influencers on price (e.g. SF real estate market) result in a lower cap rate and less risky investment

Micro-level market influences

  • Property desirability rankings should be inversely correlated to cap rate (lower desirability / higher cap rate)

Type of property

  • Retail v. Residence -> Residence is less sensitive to economic trends (e.g. retail can get hit hard by recession). Therefore, a residence should have a lower cap rate.

References

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