As a 1031 Exchange Specialist, I often talk about capitalization rates with investors looking to make smart property decisions. Get a glimpse of an investment property’s profitability by taking a closer look at this one telling percentage – it’s a revealing snapshot of its financial prospects. It’s one of the first things investors consider – even before they perform due diligence. But what exactly are capitalization rates and how can you use this knowledge to make informed investment choices?
Browse our sections with ease – we’ve put together a straightforward table of contents just for you.
- Understanding Capitalization Rates
- The Importance of Capitalization Rates in Real Estate
- The Cap Rate Formula: Breaking It Down
- Calculating Cap Rate: An Example
- What is a “Good” Cap Rate?
- Impact of Interest Rates on Cap Rates
- Conclusion
Understanding Capitalization Rates
In simple terms, the capitalization rate (or cap rate) is the expected rate of return you’d make on a commercial real estate investment property purchased in cash, at its current market value. Think of it as a profitability scorecard – it boils down to a percentage that reveals the property’s earnings potential.
Picture this scenario if you were to buy a property today, how long would it take for the rental income to pay back your initial investment? Here’s the secret to uncovering the answers you need: the cap rate.
Real estate investors, listen up! The secret to extracting maximum value from your properties lies in capitalization rates – a make-or-break factor in the world of real estate.
Capitalization rates – are they really that crucial to grasp? They allow investors, like those completing a 1031 Exchange , to compare properties. Investors can use cap rates to compare properties in different areas, of different asset types, using a common, standardized method. Is an investment worth the risk? This comparison gives investors a clear answer. It boils down to this: they can efficiently evaluate each property’s potential to deliver their target returns, so they’re only focusing on the most promising investments.
For seasoned investors working with Real Estate Agents , the cap rate can be calculated mentally to quickly assess a potential deal. However, it’s best practice to perform a more detailed calculation, as certain variables, like vacancy rates and operating expenses, can vary. Property returns can get a serious boost or bust from these differences.
The Cap Rate Formula: Breaking It Down
While capitalization rates might seem complex, the formula itself is actually straightforward. To calculate the cap rate, you only need two numbers:
- Net Operating Income (NOI)
- Current Market Value
Here is the basic formula: Capitalization Rate = Net Operating Income / Current Market Value
Let’s examine these variables more closely:
Net Operating Income (NOI)
Net operating income, often referred to as NOI, is the annual income generated from the property. To arrive at NOI, we total the annual income of the property and subtract the annual operating expenses. Annual income would include any and all sources of income, such as rents collected, parking fees, or income from laundry facilities.
It is important to consider the costs associated with managing the property as these will impact the net operating income, and ultimately, the return on investment. Common expenses to factor in when evaluating potential rental properties are property taxes, maintenance costs, property management fees, homeowner association (HOA) fees, if applicable, and insurance. You’ll also need to account for any potential vacancy throughout the year, as it’s highly unlikely your property will remain fully occupied. This is especially true if dealing with short term rental properties.
However, you would not subtract the mortgage payment when calculating NOI.
Market Value
Market Value is what a property is currently worth on the open market in its “as is” condition. In other words, what a buyer would realistically be willing to pay for your property in its current condition. The easiest way to arrive at this figure is by hiring a licensed, independent, third-party appraiser. Appraisers typically charge between $300 and $600. Other methods for estimating current market value are Zillow Zestimates or by asking your broker or Real Estate Agent to provide you with comparable sales data.
Calculating Cap Rate: An Example
Assume you’re evaluating a rental property that generates $30,000 annually in rental income and has monthly operating expenses of $800. The current price tag on the property? A whopping $400,000. Let’s start by calculating the Net Operating Income (NOI):
Net Operating Income = (Monthly Rental Income x 12 Months) – (Monthly Operating Expenses x 12 Months)
Using our example, the calculation would be:
Net Operating Income = ($2,500 x 12) – ($800 x 12) = $30,000 – $9,600 = $20,400
Therefore, the annual Net Operating Income (NOI) in our example is $20,400.
Now that you know the Net Operating Income is $20,400, divide this amount by the market value, which in our case, is $400,000.
Capitalization Rate = NOI / Market Value
Capitalization Rate = $20,400 / $400,000 = .051 or 5.1%
What is a “Good” Cap Rate?
A common question amongst my clients, and particularly those newer to commercial real estate is “What is a good cap rate?”. Unfortunately, there is no single good or bad cap rate as these rates fluctuate and are dependent upon several variables. Some of the variables that impact cap rates include property type, location, condition, local market conditions, amount of risk involved and even interest rates. For example, a cap rate of 8% in one market may be considered fantastic, whereas a cap rate of 5% in a stronger, more desirable, market like San Francisco or Manhattan may be the best you can expect to achieve given high real estate values and competitive market conditions.
For comparison’s sake, think about it this way. Although many real estate investors would love to own a single family home that cash flows like a rockstar with double digit cap rates, the capitalization rate would generally need to be lower on multifamily apartment buildings because of economies of scale. You’ll typically generate greater Net Operating Income (NOI), appreciation and the inherent diversification provided by having multiple tenants. Just imagine for a moment having all of your units being vacant simultaneously with a portfolio of several single family homes.
In general, it’s easier to find replacement tenants for a single unit than an entire home, especially if rental properties in the area are plentiful. This in turn mitigates investor risk with apartments. Lower vacancy, greater cash flow, economies of scale, and diversification lead to more demand, higher property valuations and thus lower cap rates.
With every interest rate adjustment, investors should reflexively consider the ripple effect on cap rates, recognizing that this seemingly distant relationship can quietly alter the viability of their entire investment strategy.
Real estate cap rates are heavily influenced by the Federal Reserve’s actions, which inherently shape the interest rate landscape. The old adage “money doesn’t grow on trees” is taking on new meaning, courtesy of the Federal Reserve’s ongoing campaign to hike interest rates. The sobering reality? The cost of borrowing just got a whole lot steeper.
With interest rates steadily increasing and with more expected increases on the horizon, the cost of debt becomes more expensive. As a result, Net Operating Income, a key component of the cap rate calculation, shrinks. This forces buyers and sellers to accept lower prices for their properties. Conversely, in a declining interest rate environment, we typically see the opposite take effect.
When financing costs become more affordable, investors have more capital available. They are also more willing to pay more for similar assets. When the tables turn, sellers get to call the shots.
When sizing up a property, there’s one metric that really matters: capitalization rates. Investors can rapidly assess a property’s income potential thanks to these aids. Just as importantly, because the calculation standardizes returns, you’re better able to compare properties across markets. However, you need to remember that it only tells part of the story. Do not make the mistake of investing in properties based solely on the cap rate.
Wrapping it all up, we’ve reached the final stretch. This is where the hard work pays off and the results become crystal clear.
Looking to buy a property that’ll actually turn a profit? Capitalization rates hold the key to making an informed decision. But like any investment metric, use cap rates alongside other data points, like market trends and your own investment goals, for a complete picture. Building a strong foundation in these concepts lets you team up with experts and tackle the real estate market head-on.