Understanding CAP Rates Can Make You Money!

Real estate valuation is a very complex business with many variables that affect price. Over the years real estate people have found that they needed a way to compare property values, essentially price, in a market using a shorthand method.This is how capitalization rates or cap rates came into general use. In a way, the cap rate tells you what investors expect to earn as a percentage of their investment. For example, a buyer who thinks a facility is worth a cap rate of 10.5 is saying that he wants a 10.5% return on his investment.

Capitalization or “cap” rates play a central role in real estate investment, financing and valuation decisions. Average market-wide cap rates are widely quoted and followed as a gauge of current real estate investment market conditions.

Cap rates received increasing attention in both industry and academic circles over the past decade, as real estate established itself as a mainstream asset class that became more integrated with broader capital markets, on both the debt and equity sides.

The resulting surge of capital into the real estate sector over the last decade helped drive property values to historical highs and cap rates to new lows. The phrase “cap rate compression” was born as cap rates fell from the 8-10% range in the early 2000’s to 5-7% by 2006 (Exhibits 1 and 2). During this period, and especially the later part of it, the appropriate level of cap rates was widely discussed and debated amongst the “new paradigm-real estate risk has been permanently re-priced” and “pricing bubble” camps. Today, as the real estate sector works its way through a deep financial crisis-induced recession, cap rates are increasing and investors are struggling to get a handle on just how high they will go and where they will settle once a new equilibrium is reached. Moreover, in today’s environment, characterized by limited transaction activity, market derived information about cap rates is not widely available.

Exhibit 1 Exhibit 2

 

At Home Expo Gallery, we use Cap Rates as a primary gauge of the value of investing in real estate.  We will help you understand what it is and how it should affect the price you set for your property or the price you should pay in buying a property.  Contact us and we will explain how this matters for you.

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