As you can see, the type of property you’re talking about makes a big difference. In fact, when you consider the "class" or quality of a property, there are more than five percentage points of difference between the lowest and highest in CBRE’s survey. The highest cap rate (9.74%) is for suburban economy hotels, and the lowest (4.69%) is for Class A (top-quality) urban apartment buildings.
Why cap rate is important for real estate investors
There are two main reasons why cap rates are important.
The first reason is to analyze the performance, or expected performance, of your rental properties. For example, if there are three office buildings in your price range for sale, calculating the expected cap rates for all three can help you determine which is the best investment. Or, if you know the market average cap rates, calculating the cap rate of properties you own can help you determine if they're overperforming or underperforming the industry averages.
The second reason to use cap rates is when you’re considering the sale of an investment property. A little algebra tells us that we can rearrange the cap rate equation to this:
Market value = net operating income / cap rate
Here’s why this is important if you’re selling a property: If you know how your property’s net operating income and the industry average cap rate, you can determine your property’s fair market value.
For example, if you know that the average office building has a 7% cap rate and you own an office building with net operating income of $100,000, understanding the cap rate equation tells you that your property has a fair market value of about $1.43 million.
Cash-on-cash return could be a better return metric for you
As we’ve seen, cap rate can help you compare properties, assess your property’s return, or help you figure out how much you should expect to get when selling a property. However, cap rate isn’t the most useful metric for calculating investment property returns.
Specifically, there are some real-world costs that cap rate doesn’t consider: loan repayment.
For this reason, cash-on-cash return can be a more useful concept when calculating investment returns. This is a measurement of an investment’s net income—including debt repayment—divided by the actual cash you invested in the property.
For example, let’s say that you acquire a $1 million office property and that you put down a 25% down payment ($250,000). Including closing costs and other acquisition expenses, your total cash outlay is $300,000.
The property generates $110,000 in annual rental income and produces net operating income of $70,000 after expenses. On top of this, you pay an additional $40,000 in mortgage principal and interest each year, so your property’s total cash flow is $30,000 for the year. Dividing this by the $300,000 you spent to acquire the property produces a cash-on-cash return of 10%.
If you acquire a property in cash, your expected cash-on-cash return and cap rate should be identical in most cases.
The bottom line
Cap rate can be useful to real estate investors in numerous situations, including
- evaluating potential investment properties,
- assessing the performance of properties you own relative to others, and
- determining a fair market value for your properties.
However, there’s no easy answer to the question "What is a good cap rate?" There are too many variables that determine cap rates for property types and too much variation to give a one-size-fits-all answer.
While there’s no specific "good" or "bad" cap rates, understanding the concept can help you make smarter real estate investment decisions and evaluate the performance of your properties.