What on Earth is a Cap Rate?

A cap rate, or capitalization rate, is the litmus test in real estate for determining the potential annual rate of return of an asset on an all cash basis. A property being sold for $1 million at a 10% cap rate can reasonable be expected to produce $100,000 of annual profit if the investor purchased the property for a million dollars cash. Likewise, a property purchased for $10 million cash at a 5% cap rate can be expected to produce $500,000 in annual profit. Break it down further, you ask?

All Cash Purchase Price  x  Cap Rate (move your decimal)  = Annual return

Cap rates vary based on risk. There is risk in the market in which the property is located, risk in the age, quality, upkeep, and build date of the asset, as well as overall macro trends within the housing industry. Therefore, an investment a brand new, 350-unit, class A apartment community, located within walking distance of downtown Austin, surrounded by anchor employers will be a much less risk investment compared to a 30 unit, class C building, built in the 1960's, in the middle of Lufkin, Texas. These two properties and their markets are wildly different, and thus the demand and risk tolerance required in both deals are also much different. The Austin property property will most likely trade with a cap rate of 3% (less risk, lower potential return) and the Lufkin property around 10% (more risk, higher potential return).

The Austin property would probably trade for some ridiculous price, like $200,000 per door, or $70,000,000 and the Lufkin property would yield something a little more modest like $30,000 per door or $900,0000 total. What is your expected return based on the purchase price? That is a cap rate

Austin

$70,000,000 x .03 = $2,100,000

Invest $70 million all cash and you can reasonably expect to return $2.1 million a year in profit. 

Lufkin

$90,000 x .1 = $9,000

Invest $90k all cash and you can reasonable expect to return $9k a year in profit.