We're going to look at these factors in a bit more detail. But first, let's define what a cap rate is and give a brief example.
If you already know this, feel free to skip past this next section.
What is cap rate?
What is cap rate in real estate? Cap rate, or capitalization rate, is a measurement used to compare various real estate investments or markets. It’s most often calculated as the ratio between Net Operating Income (NOI) and a property's original acquisition cost (including upfront repairs and expenses).
Net operating income (NOI) is the annual income generated by the property after deducting all operational expenses. This includes both property management fees and taxes but does not include any mortgage payments.
NOI = Gross Rental Income – Vacancy, Taxes, Insurance, Maintenance, Other OpEx expenses
The cap rate is the rate of return you can expect on your investment based on how much income you believe the property will generate for you. The higher the cap rate, the better.
Here is the cap rate formula:
Cap Rate = NOI/Purchase Price × 100%
You can use cap rate in various ways including:
To analyze an individual property
To compare multiple investment properties
Cap rate example
You can run a calculation for the cap rate by using the net operating incomes and recent sales prices of comparable properties.
The cap rate is determined and then applied to the property you are considering purchasing. This helps to determine its current market value based on income.
It's important to remember the inverse rule: The lower the cap rate, the more expensive the property. The higher the cap rate, the cheaper the property.
Below is an example of a calculation for cap rate for three different properties:
Property A - On the market for $750,000, has an annual income of $85,000 and annual expenses of $50,000
Calculation for cap rate: ($85,000 – $50,000)/$750,000 x 100% = 4.6%
Property B - On the market for $700,000, has an annual income of $75,000 and annual expenses of $35,000
Calculation for cap rate: ($75,000 – $35,000)/$700,000 x 100% = 5.7%
Property C - On the market for $1,000,000, has an annual income of $130,000 and annual expenses of $60,000
Calculation for cap rate: ($130,000 – $60,000)/$1,000,000 x 100% = 7%
The cool thing about understanding the cap rate equation is, if you know 2 of the parts, you can easily find the 3rd.
For Example: If a building sells for $1M at a 4% cap, you then know the NOI is $40,000.
4% (Cap Rate) = X (NOI) / $1,000,000 (Purchase Price)
X = $40,000 (NOI)
Which factors influence a good cap rate
This next part is a continuation of the introductory section.
There are many factors that influence what a good cap rate is.
Remember, just because you buy a property that has a good cap rate initially, doesn't mean it's going to perform well in the future.
Current rental income of the property
The current rental income of a property determines its cap rate.
Ideally you want the rent to be as high as possible when you first buy the property, which will cause the NOI to increase giving you a higher cap rate. Remember, the NOI is calculated by subtracting operating expenses from the total revenues of a property.
The issue with most investors is that they will only look at the rental income at its present value.
What you want to do instead is determine the cap rate once you add value to the property. This could mean replacing roofs, mowing the lawn, or any other work which helps to increase rents. When rents increase, so does the cap rate.
Rent pro forma
Unless you are buying class A properties, you will most likely be doing work on your properties. Once the value-add work is complete, the goal is to be able to both charge higher rents and reduce your vacancy rate.
To predict what rent and vacancy rates will be in the future, investors will use a rent pro forma.
A rent pro forma is a detailed breakdown of the income and expenses of a rental property once it is fully stabilized and operating at peak efficiency.
Peak efficiency means that it has the market rents, income, vacancy rates, and operating costs compared to other properties with a similar class and age in that market.
Like most ROI calculations, determining what is "good" has a lot to do with your risk tolerance.
To further explain, let’s take a look at two investments, one that’s a 5% cap and one that’s a 7% cap rate.
The property with a 5% cap rate may be a good fit for an investor looking for more of a passive and stable investment. It might be in a better location currently, but has a lower chance of rapid future appreciation.
The property with the 7% cap rate is a better fit for an investor that’s willing to take more of risk. But with risk, often comes reward. Though less stable, this property will have higher upside potential for appreciation.
Future appreciation and gentrification
Some real estate investors consider appreciation a "nice to have" compared to cash flow. This is due to the fact that it's simple to project cash flow. But it's extremely difficult to predict appreciation.
Let's say you buy a property with 5% cap rate and another property with a 10% cap rate. Right off the bat, the 10% cap rate property is doing much better. It's generating more revenue and is in a more stable neighborhood. But, what if the 5% cap rate property was in Williamsburg, NY 10 years ago? Or The Arts District in Los Angeles 7 years ago?
Property prices literally doubled in value within a 2 year period in both of those markets. The 5% difference cap rate is negligible when you take into account returns you'd get by owning a property in one of those neighborhoods.
As seen above, cap rate is very dependent on the particular market you’re looking in. We all know that property in the San Francisco Bay Area generally costs more than property in the Midwest. That means that $1M can be used to purchase assets that bring in vastly different NOI. For example:
A $1 million building with a 7% Cap, has a $70,000 NOI.
A $1 million building with a 4% Cap, has a $40,000 NOI.
These properties have the.same purchase price, but different returns based on location and market.
Cap rate is also affected by surrounding buildings. When looking at two buildings in the same neighborhood, one that was recently updated and one that was not, the updated one might trade at a 5% cap, whereas the one in need of renovations may trade at a 7% cap.
Lower cap rates mean less risk and higher cap rates are higher risk, so it’s up to you to decide on the investment type you want.
Differences between most popular ROI calculations
A lot of investors can get confused by the difference between the different ROI calculations that one can use to determine the worth of a property.
Cash-on-cash return measures your received pre-tax cash flow relative to the amount of money you invested to acquire the property.
It is the other most popular calculation for the ROI of a rental property. You can calculate the cash-on-cash return of a property by dividing the received net cash flow for the year by the amount of cash invested.
What is cash flow exactly?
Cash flow is income generated when your rental returns exceed your monthly expenses. The calculation for that is the total income, or rent return, you can receive from a property minus the total expenses you will accrue.
It's one of the most popular ROI calculations. For buy-and-hold investors, cash flow is king. Head over to our blog on cash flow to understand what can affect this calculation, like the 50% and 1% rules.
Determine profitability - Cap rate is the best ROI method to determine if a property is immediately profitable. This is because it's comparing the income you are receiving to the actual price you are paying for the property.
Compare investment properties - Cap rate is a great tool to compare investment properties at their current state. This is helpful if you have three properties right next to each other, of a similar property type, and are all the same price. Whichever property is generating the most income will have the highest cap rate, and will be the obvious decision which property to buy.
Estimate the payback period - Cap rate is helpful to quickly calculate a payback period for an investment property. To calculate the paybackperiod, you'd divide 100 by the caprate. For a property whose caprate is 10%, for example, you'd be looking at a 10-year paybackperiod.
Accurate calculation: Cap rate does not include any mortgage expenses. This is beneficial because it gives more of an accurate analysis by not factoring in financing (terms, interest rates, etc.). In other words, it focuses on the property alone without any of the distractions of financing.
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