Capitalization rates and estimated property values

Capitalization rates, also called “cap rates,” are a way to determine the value of buildings like offices, shops, and apartment buildings that make money. It’s the amount of money you make in a year from rent, divided by how much the building is worth. Cap rates are shown as a percentage, like 5% or 7%.

Let’s say you own an apartment building. You get $100,000 per year in rent from the people living there. A person wants to buy your building, and they use a 5% cap rate to figure out a fair price. To get the value, they divide the $100,000 you make each year by 5%. This comes out to a value of $2,000,000 for your apartment building.

How Cap Rates Affect Property Values

The cap rate has a big effect on a building’s worth. A lower cap rate means the building is worth more money, while a higher cap rate means it is worth less.

Low Cap Rates = High Property Values

When cap rates are low, like 4% or 5%, it makes values go up. Let’s go back to that apartment building making $100,000 per year. With a 5% cap rate, it was worth $2,000,000. But if most apartment buildings are selling based on a 4% cap rate instead, now the value is $2,500,000. The math is $100,000 divided by 4% = $2,500,000.

Low cap rates are common in places where a lot of people want to buy buildings. Big cities like New York have lower average cap rates. It’s like how everyone wants the new iPhone, so Apple can charge a lot of money for it. There’s a lot of demand.

High Cap Rates = Low Property Values

When cap rates are high, like 8% or 9%, you get lower values. If apartment buildings are selling at an 8% cap rate, that $100,000 in rent now gives a value of $1,250,000. The math is $100,000 divided by 8% = $1,250,000.

Higher cap rates happen when there isn’t as much demand. People can’t or don’t want to pay as much money to buy buildings. This could be in smaller towns or if the economy isn’t doing well. It pushes the values down.

What Makes Cap Rates Go Up or Down

A lot of things affect whether cap rates are high or low. Here are the big ones:

The Economy

When the economy is good, more people want to buy buildings. Companies are making money and hiring more workers. Those workers need places to live too. This makes cap rates go down and values go up.

In bad economies, it’s the opposite. Companies aren’t doing as well and might lay people off. Fewer people are buying buildings. This makes cap rates go up and values go down. It’s kinda like how not as many people are buying houses or fancy purses when times are tight.

Interest Rates

When banks are charging low interest rates, it’s cheaper to borrow money. More people want to buy buildings because the loans cost less. This makes cap rates go down.

If interest rates go up, not as many people can afford to buy. The monthly payments on the loans cost a lot more. So there’s less demand to buy, which makes cap rates go up and values come down.

Location

Certain cities and neighborhoods are really popular places to own buildings. Usually it’s areas with a lot of jobs and people. There’s more demand from people wanting to buy in the best locations. This pushes cap rates down and values up.

Places losing people or jobs aren’t as attractive. There won’t be as many people wanting to buy buildings there. So cap rates tend to be higher and values lower.

Type of Building

Some types of buildings are more popular with buyers. High-quality office towers or fancy apartment buildings see a lot of demand. Investors like them because there’s less risk. They can charge high rents and get decent income from the buildings. These tend to have lower cap rates.

Old shopping centers or run-down motels aren’t as appealing. They come with more risk. The income isn’t as certain. So buyers expect higher cap rates, giving lower values.