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What Is A Cap Rate in Real Estate? Everything You Need to Know

When comparing potential investment properties, it’s important to be sure that you are comparing apples to apples. One way to do this is by analyzing the capitalization rate, or cap rate, for each property. Cap rates indicate the rate of return on an investment property in proportion to the value of the property. Read on to learn how to calculate, compare, and analyze cap rates. 

Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More

Understanding Cap Rates

Cap rates allow investors to more accurately compare the true investment potential of a property. When comparing revenue alone, a large or expensive building will frequently appear to be the best investment, simply because it has the most money coming in. What that does not bring to light, though, is how healthy that building’s income is after expenses and in proportion to its value. That is where the cap rate comes in. 

The cap rate is a percentage that expresses the building’s net operating income divided by the current market value of the building. This rate is far from the only factor investors should consider when deciding whether to invest, but it is one important element to factor in. 

Cap rates are most helpful for comparing buildings or properties against each other. Just as an investor may consider the cost per square foot between buildings, they can use the cap rate to compare the proportion of net operating income to market value. With cap rates, a higher percentage may be preferred by investors, because it indicates better value for the current purchase price with higher revenue opportunities. Sellers would rather see a low cap rate, which would correlate with a higher sale price and less of a ‘bargain’ for the buyer.

Calculating Cap Rates

There is more than one method to calculate a cap rate in real estate. Always keep this in mind when comparing cap rates that you did not prepare yourself. Do not be afraid to ask what method was used, and consider using each method individually to analyze potential real estate investments

The two main methods for calculating cap rates are 1. Net operating income divided by current market value and 2. Net operating income divided by the purchase price. Here’s what you need to know:

Method #1: Net Operating Income Divided by Current Market Value

The most common formula for determining the cap rate is net operating income divided by current market value. The net operating income is expected annual gross income minus the expenses incurred for managing and operating the property. The current market value is the value based on today’s market in that location.

Method #2: Net Operating Income Divided by the Purchase Price

Alternatively, some people calculate the cap rate as the net operating income divided by the purchase price. This method is more commonly used for investors comparing their own portfolio rather than analyzing a series of properties for prospective purchase. It gives unrealistic rates for properties that enjoyed a massive increase in equity over the course of several years, or even decades. 

Regardless of which method is used, cap rate calculations always assume that the property was purchased with cash. This makes the formula more accurate by eliminating the variable of lender financing terms. It also presents one of the challenges of cap rate reliance, because many projects will be financed.

A Note on Calculating Net Operating Income

Many methods for calculating net operating income exist. Some will hypothesize the building’s performance to create an expected NOI. Others use the actual income and expenses for the past twelve months. 

If properties have undergone some noteworthy changes in the last few months, good or bad, a NOI using only a few months’ records may be appropriate. This might happen if vacancy rates plummeted after a hospital opened nearby or the owner adjusted rent rates to be more in line with the market. 

Factors That Influence Cap Rates

Cap rates are highly variable due to the nature of the calculation: it is based on expected net operating income and current market value. Knowing the way someone calculated the net operating income and current market value allows an investor to better compare properties based on cap rates. Keep the following factors in mind when comparing cap rates of potential property investments:

  • Location. The value of the appeal and suitability of the property’s location for its intended purpose cannot be understated. This both impacts current market value and the net operating income. Ideally situated properties can be expected to have lower vacancy rates and generate more in rent revenues than properties that are less ideally located.
  • Property type. When determining the cap rate, one must consider the likelihood of vacancy specific to the use of that property. The property’s industry is therefore an important consideration when valuing an investment. For instance, commercial multifamily properties provide a relative certainty of income from rent collection, as people will always need a place to live. As 2020 demonstrated, we do not always need retail space for shopping or commercial space for businesses—but demand for housing rentals actually increased. 

What Is A Favorable Cap Rate?

Generally speaking, cap rates in the 8-12 percent range are considered good for real estate investments. However, “good” is a relative term that can vary wildly based on the market of the property and the individual investor’s goals. Remember, cap rates are heavily influenced by location and property type, so a good rate in Los Angeles might not be such a great rate in Tulsa, Oklahoma. When comparing cap rates, be sure you’re comparing rates for properties in similar markets

Comparing Risk Versus Reward

We initially examined cap rates as an expression of possible return based on the funds invested. Looking more closely, though, cap rates also quantify the level of risk that comes with the purchase of a property. 

This leads to an important consideration: cap rates have an inverse relationship to asset value. If the property value rises, the cap rate falls, and vice-versa. With higher value properties, there is less wiggle room for a return on investment. At the same time, however, there is also less risk. Undervalued assets, on the other hand, present an opportunity for greater return on investment—but they typically present greater risk as well. 

We say this often, but the best investment is always the one that best aligns with the investor’s tolerance for risk. Some investors thrive in the big-risk, big-reward arena, while other investors prefer lower cap rates in the pursuit of less risky passive income

Low cap rate properties with highly valued assets may represent a sweet spot representing moderate risk for moderate return. This type of investor is comfortable tying up a large amount of money for more modest returns over time, because they have the security of knowing they can always sell the asset. 

Limitations of Cap Rates

Cap rates are best for quick comparisons between similar properties in similar markets. The formula is imperfect and will not fully capture the risk and value of properties. 

Arriving at a figure for net operating income is an element of the calculation that introduces some significant human discretion and has the potential to leave out some key facts regarding the property.

Net operating income is the annual income minus the expenses for managing the property, upkeep, and taxes. These numbers may not fully reflect the financial situation of a building in need of major repair or renovation. 

Here are few property characteristics that can create a misleading cap rate:

  • The cap rate may not adequately capture the income potential of a property 
  • Cap rates do not account for debt on the property
  • Significant projected changes to the local rental market may not be reflected in the current market value
  • Buildings can quickly become functionally obsolete in a manner that slashes potential rental income and decimates the pool of potential renters

Final Thoughts

Real estate cap rates provide a way for investors to compare earnings potential of properties. These rates can help investors project the length of time it will take to recoup the cost of the project and make a decision on which property to invest in when comparing properties in similar markets. 

The number one point that investors must remember is that cap rates can only be one portion of the analysis that occurs when purchasing an income-producing property. Cap rates are highly variable due to a calculation that is dependent on projected income and the current market value. Both of these figures fluctuate due to market forces and can be influenced by the person preparing the calculation. Even so, comparing cap rates alongside other due diligence can help you find the right investment opportunity for you.

Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More

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