One commonly used metric for evaluating investment property is the capitalization rate, or cap rate. Overly simplified, it’s what your annual rate of return would be if you purchased a property with all cash (no mortgage). Put another way, the cap rate is what investors are willing to pay for a dollar of net operating income (NOI). It is calculated as follows:
Cap Rate = Net Operating Income
The main value of a cap rate analysis is its ease and simplicity. By knowing or estimating the annual rents and expenses, and considering the asking price, you can quickly gauge the “asking” cap rate.
Market cap rates vary significantly by property type (e.g. multifamily/residential, retail, office, etc.), by location and other factors (e.g. creditworthiness of tenants, length of leases that are in place, etc.).
Other important considerations:
- Consider whether you are (or should be) evaluating the current/in-place net operating income or the projected net operating income. If the property is under-rented/substantially vacant, then looking at just the current cap rate may not provide a reliable assessment.
- Consider what expenses you are including, and excluding, in your calculation of net operating income. This will have a direct impact on the cap rate analysis. For instance, if you are analyzing a property that shows no property management fee in their operating statement but you are planning to hire a property management company, then that needs to be factored into your analysis.
If you have questions about buying or selling investment property in or around Boston, please contact us. We are also happy to share recent market reports with cap rate trends.