Cap rates offer a measure of real estate investments

Becca Posner
Becca Posner

Most financial advisors recommend their clients diversify their investments. While many people hold stocks and bonds, real estate offers not only diversification, but also a potentially lucrative venture.

One of the most common term that comes up in discussing an investment property is its capitalization rate, which estimates the annual return on an investment. 

To find the cap rate for a particular property, determine the ratio of two variables — the asking price and net operating income (NOI).  The NOI is an important factor in determining the return on your investment. This number is calculated by adding all the revenue earned in one year and subtracting all the operating expenses. If a property is listed for $500,000 and the NOI is $50,000, the cap rate would be 10 percent. 

Local demand constitutes one of the driving forces behind cap rates and investment risk. Mature, competitive markets generally have higher property values because the demand is greater. Smaller markets have lower property values, but pose increased risk because there’s more uncertainty. Property for sale in rural markets has higher cap rates than those in larger, wealthier and more populated areas. 

Cap rates only evaluate some of the risks and rewards of an investment. The calculation only accounts for the NOI from one stabilized year of income and assumes a cash purchase. The calculation doesn’t take into account such additional expenses as interest, fluctuations in operating expenses or the market, total building vacancy or any other unforeseen costs. Cap rates provide insight into the health of a local market, but don’t consider all the risks involved. It’s up to investors and their brokers to know the market and desirable cap rates.

The average cap rate in Grand Junction and Mesa County has held steady for several years at 7.5 percent to 8.5 percent. The Denver market averages 6 percent to 6.5 percent, while such aggressive markets as Los Angeles and San Francisco average between 4 percent and 5 percent. The Grand Valley market is healthy and growing slowly. As we see more growth and higher demand, the cap rate is expected to drop.

It’s safe to say real estate offers a potentially profitable investment, but there’s always unpredictability.