As a real estate investor, it’s important to know at all times if your investments are profitable. If you don’t, then you can quickly dig yourself a hole that could be extremely difficult or impossible to get out of.
While this can seem daunting, particularly if you’re new to real estate investing, it doesn’t have to be, and in this article we’ll be talking about how you can figure out the return on investment for your properties using the cap rate method.
What is Cap Rate?
The cap rate, or capitalization rate, is a term used by real estate investors to indicate the rate of return that is expected to be generated on a real estate investment. This is based on the income which the property is estimated to generate for the investor.
Knowing your cap rate is vital because it helps you to see whether a property will generate a worthwhile return for the time and funds which you have invested in it. This number is displayed as a percentage, and it’s generally a reliable way of estimating your return on investment.
Determining the cap rate for rental properties is a great way for investors to compare different real estate investments. If there are two buildings on the market at completely different prices, it can be difficult to determine which constitutes the better investments.
A building that costs $600,000 is not necessarily a better investment than one that costs $700,000 just because its purchase price is lower.
Rather it is important to understand how much of a return on investment each building is likely to produce and comparing two cap rates can help an investor make this determination.
Cap rate can also be a good starting point for investors looking to break into the world of real estate.
The cap rate for rental properties is also a useful tool for evaluating a property’s profitability over time. If a property’s net operating income rises while its market value remains the same, its cap rate will rise.
For an investment property to remain profitable as time goes by, its net operating income must increase either at the same rate as its market value or at a greater rate.
The cap rate is a strong measure of whether a property is becoming more or less profitable.
START SEARCHING FOR HOMES THAT BUILD WEALTH!
How Do You Calculate Cap Rate?
There are a few different ways to calculate the cap rate for your investment property, but we’re going to talk about one of the most common and easiest formulas which you can use.
Cap rate = Net operating income / current market value
The “net operating income” is the expected annual income which will be generated by the property. So, for example, if you planned to purchase a property which would rent for $2,000 per month, then your net operating income would be $24,000, but you also need to take expenses into account.
This means you need to deduct anything required for the upkeep of the property such as insurance, taxes, property management fees, and estimated maintenance costs from this number.
While it can be tough to budget for everything, some people set aside 1% of the total property value for maintenance costs every year. Once you have your net operating income figured out, divide it by the current market value of the property to get your cap rate.
As an example of cap rate, let’s assume that you’re looking to buy a million dollar property, which you estimate will return you $70,000 per year.
$70,000 / $1 million = 7% cap rate
Cap Rate Examples
Let’s assume you have $10,000,000 to invest and 10-year treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks.
But what if you were presented with an opportunity to sell your treasuries and instead invest in a class A office building with multiple tenants?
A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate.
Suppose the acquisition cap rate on the investment property was 5%. This means that the risk premium over the risk-free rate is 2%.
This 2% risk reflects all of the additional risk you assume over and above the risk-free treasuries, which takes into account factors such as:
- Diversity of the tenants
- Age of the property
- Underlying economic fundamentals of the region including population growth, employment growth, and inventory of comparable on the market.
When you take all these items and break them out, it’s easy to see their relationship with the risk-free rate and the overall cap rate.
It is important to note that the actual percentage of each risk factor of a cap rate and ultimately the cap rate itself are subjective and depend on your own business judgment and experience.
Is cashing in your treasuries and investing in an office building at a 5% acquisition cap rate a good decision?
Well, it depends on how risk averse you are. An extra 2% yield on your investment may or may not be worth the additional risk inherent in the property.
Perhaps you’re able to secure favorable financing terms and using this leverage, you could increase your return from 5% to 8%. If you are a more aggressive investor, this might be appealing to you.
On the other hand, you might want the safety and security that treasuries provide, and a 3% yield is adequate compensation for this downside protection.
How Cap Rates Affect Interest Rates
One of the most complex and least intuitive parts of understanding cap rates is their relationship with interest rates.
Often in real estate, cap rates for rental properties may shift without any change to the actual property or surrounding area but only as a result of a change in interest rates.
That is because investing in real estate property is largely driven by the amount of debt that can be borrowed to purchase a property and resulting spread between the interest rate and the cap rate. The larger the spread, the better the potential return.
This makes sense if you think of the interest rate as the cost of money, and the cap rate as the value of that same money when invested in the property.
Artificially adjusted interest rates (such as those set by the Federal Reserve) can artificially impact cap rates.
Imagine a stabilized apartment building which was purchased for $10 million and generates $750,000 in NOI each year (7.5% Cap Rate.
The property was financed with $6million of debt at a 5.0% interest rate, which costs roughly $386,000 per year.
This would make the levered yield 9.1%
Now, imagine that a few years have passed. Nothing has changed about the deal, but the interest rate on a new loan with the exact same terms as the original has increased from 5.0% to 6.0%.
This would increase the cost of the debt service to roughly $430,000 per year. In order to achieve the same levered yield of 9.1%, a buyer would only be willing to pay $9,516,000 for the same property.
The property value has decreased by nearly $500,000 and the cap rate has increased from 7.50% to 7.88%, even though nothing changed about the property itself.
The implication for the cap rate increase is that the risk of the investment also increased, but in reality, this doesn’t seem like the case. After all, you’re still dealing with the same asset in the same market, all that changed was the interest rate.
Going back to the fundamentals of finance, you’ll recall that the return on any investment can be broken into two parts: the risk-free rate of return, which is usually defined as the rate of return on the US Treasury note, and the risk premium which is the extra money you’re getting paid to compensate you for the additional risk you’re taking on.
This principle holds true for asset values across the economy. If the risk-free rate of return increases, then the amount of money you would be willing to pay for an asset that generates an additional risk premium would decrease accordingly.
What is a Good Cap Rate for Rental Properties?
What is a good cap rate?
The short answer is that it depends on how you’re using the cap rate.
The concept of a “good” cap rate is more subjective than objective.
If for nothing else, capitalization rates have become synonymous with risk more than anything else. Therefore, in order to determine a good cap rate for rental properties, you must first identify how much risk you are comfortable exposing yourself to.
According to Entrepreneur, “Different cap rates represent different levels of risk. Low cap rates imply lower risk, higher cap rates imply higher risk.” Therefore, you shouldn’t be asking yourself “what is a good capitalization rate,” but rather “what’s the right cap rate in proportion to the amount of risk you are willing to tolerate?”
An investment property cap rate may sound simple, but its implications are heavily weighted. After all, those that can accurately estimate a property’s cap rate stand a better chance at realizing success.
In the example given earlier, investing in a 10-year treasury bond would be a good fit for investors looking for a more stable, passive experience.
While investing in a class A building with multiple tenants is a good fit for the more entrepreneurial investors. The potential returns are bigger if everything goes well. But there’s also the potential for lower returns or even losses.
Generally speaking, to answer the question “what is a good cap rate:” a cap rate that falls between 4 percent and 12 percent is typical and considered to be a good cap rate.
However, it does depend on the demand, the available inventory in the area and the specific type of property. What is a good cap rate can be subjective and various real estate investors with dissimilar investing strategies look at it differently.
For example, a 4 percent cap rate may be the norm in high-demand areas such as in and around large metropolitan areas and high-cost areas like Southern California and New York City.
In contrast, a lower-demand area like a rural neighborhood or an up-and-coming neighborhood that is in the process of gentrification, you may see a cap rate of 10 percent or higher.
Typically, buyers want a high cap rate, meaning the purchase price is relatively low in comparison to the NOI. However, a higher cap rate typically means more risk and a lower cap rate represents lower risk. A property with a high cap rate may be located in an area where there isn’t much opportunity for increasing the rent rates or where property appreciation isn’t on a scale with other areas. An investor needs to weigh the risks and determine an appropriate cap rate for their investment goals.
So, how do you know if your cap rate is good or not? Unfortunately, the answer to this question is debatable, but most people look to have a cap rate that is somewhere between 4% and 12%.
While you might be tempted to call it a day if your investment falls within the “acceptable” cap rate range, there is a bit more to it than that, unfortunately. There are actually a number of factors which might cause you to pump the breaks on an investment, even if the cap rate is arguably decent.
What Impacts the Cap Rate?
Not all properties are created equal, and there are some other factors that could impact your cap rate assessment. Here’s a short list of some things to look out for if your calculated cap rate is too good to be true.
Asset Type Impacts Cap Rate
What kind of property are you investing in? A commercial property would likely warrant a much larger cap rate, because if the economy tanks you could be sitting on a sizable amount of debt with no one to rent your space.
A residential property would likely be a safer bet because people always need housing. A slightly lower cap rate may be acceptable here if the property shows potential.
Location Impacts Cap Rate
Location is everything in real estate. So, before you decide a property is a great deal because of its cap rate you should evaluate where it is located. How difficult will it be to rent this property consistently? Are there enough jobs here to support a healthy rental economy?
Your Rental Strategy Impacts Cap Rate
What kind of rental is this? If you’re purchasing the property as a high dollar vacation rental, then your average rent will be much higher, but you might also pay more in maintenance costs than you would with a long term rental.
You should also make sure to factor in that your rental could end up sitting empty in the offseason, even if it’s in an otherwise attractive location, lowering your annual income.
Supply and Demand Impacts Cap Rate
Have you checked how many other properties are for rent in the area you plan to invest in? While your chosen rental may look like a great deal, it might not actually be if there are too many other properties to compete with.
Other landlords will continually drop their prices to stay competitive, and you could end up with either an empty property or one that is rented far beneath what you thought you were going to actually get for it. Buyer beware.
Why are Cap Rates Important?
Cap rates are important for making sure that you aren’t taking on debt for an asset that won’t be able to pay for itself. It’s easy to get fooled into thinking that you’ve picked up a great deal, but there could be a very good reason that the property has been on the market for a year with no takers.
Using the cap rate method also allows you to easily compare properties to each other. If you’ve been eyeing more than one rental for your portfolio, then the cap rate could be the deciding factor that helps you see which properties earn more money for you.
If you’re purchasing properties with financing, then the cap rate is also valuable for determining how long it will take you to own the property free and clear.
In closing, the cap rate formula is a great tool for real estate investors that’s both easy to use and useful for seeing the bigger picture. You owe it to yourself to take advantage of every tool you have to make sure that your investments are successful. Don’t ignore cap rates or you may quickly come to regret your new “asset”.
Related: How Does Rent to Own Work in 2019?