CRACKING THE CODE: WHAT DO INVESTORS MEAN BY "CAP-RATE"?
by Martin Wolf
If you are involved in real estate in any way or form you will eventually come by the use of the investing lingo -
"cap-rate". While it may seem like secret language or code between seasoned real estate investors, it is short hand for
"capitalization rate" - an economic formula that investors may use to determine the "rate of return" on income producing
real estate investment property based on the expected income that the property will generate. It is calculated as follows:
Capitalization Rate = Yearly Net Operating Income ("NOI") /Total Value (or Sales Price)
Value = NOI/Cap-Rate
Even if you have used the term "cap-rate" before, you may still be confused. You may be asking "what does rate of
return mean?" or "how is expected income give us this rate of return?". This is nothing to be ashamed of as we have all
been there. There are many apparently experienced investors out there that despite their use of the term, the extent of
their knowledge of this investment is tool is that, from a buyers' or real estate investors' perspective, the higher the
"cap-rate" - the better the investment. Many investors will rely on their brokers to tell them the cap-rate and compare
properties and as long as the cap-rate exceeds 10%, the investment would be deemed acceptable. However, the
reliance on the cap-rate given to us by a broker or a Seller without knowledge of the meaning of or how to calculate it
on your own could be dangerous and could lead to both bad investments and lost opportunities.
The best way to understand what a capitalization rate is to understand that investors want a fast return on money
invested into a property. The faster the money invested into a property is "returned" - the better. This is what is meant
by "rate-of-return". Thus, the higher the "rate of return" - the better. For example, an investor who purchases a property
for $100,000 and receives profit of $10,000 a year may theoretically be happier than an investor that purchases a
property for $200,000 and receives an annual profit of $15,000. The latter investor is taking more time to get back the
money used to purchase the property, while the former will have its money "returned" in 10 years. Thus, an investor
wants to know his rate of return and needs to be able to calculate it. How is this rate of return calculated? One way, is
by calculating the "capitalization rate".
It is important to understand that the term "cap-rate" does not mean the rate of return, but is one tool used by investors
to attempt to calculate it. There are different ways of analyzing the rate of return of a property in addition to calculating
its cap-rate. Simply put, the cap-rate is the net operating income divided by the sales price or value of a property.
The result is expressed as a percentage. For this cap-rate to be accurate, an investor needs to thoroughly perform his or
her due diligence and carefully analyze income and expenses to make sure an accurate net operating income is being
utilized to calculate the cap rate.
The capitalization rate is a good tool to quickly compare investment opportunities, but it should not be the sole factor in
any real estate investment decision. It should also be noted that the capitalization rate does not factor in mortgage
financing in calculating a property's performance. Many investors consider the amount and cost of financing as a key
factor in making an investment decision. Many more factors need to be looked at such as the growth or decline of the
potential income, the increase in value of the property, and any alternative investments available.
ABOUT THE AUTHOR
Attorney Martin Wolf is currently practicing law as a partner at the law firm of Ginsberg & Wolf, P.C. He practices law
with Superlawyer Robert Ginsberg on a philosophy of legal practice that champions the principles of dedication to client
service, professional excellence, compassion, integrity and reliability. He offers his clients aggressive and effective
legal representation and high-quality and efficient professional service in a variety of legal arenas. If you would like to
read more about Martin Wolf, click here.
CONTACT A REAL ESTATE ATTORNEY
If you need a real estate attorney, contact attorney Martin Wolf at Ginsberg & Wolf. Our main office is located in
Manhattan, with an office in Brooklyn, New York. We have handled countless real estate matters throughout the state
of New York and New Jersey.
You can contact us online or at 212.608.1660 or 212-227-0640 to discuss your real estate matter.
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