The cap rate is one of the most important but usually misunderstood key to guarantee the success of your real estate investments.
Every time you evaluate an opportunity, it is likely that your first question is about the cap rate.
However, for you to take advantage of it, you have to know first what the cap rate means and what makes a valuable thing to consider.
Cap Rate Calculator
There is a custom cap rate calculator on Master Passive Income that is a terrific calculator.
What is Cap Rate?
Capitalization rate, or simply cap rate, refers to the estimated percentage return rate that a particular property is going to produce on the investment of its owner.
To determine the cap rate, the annual net operating income is divided by the cost of the property.
The formula is crucial to identify the percentage of the return on investment that the investor hopes to recognize.
As the cap rate increases, the asset’s valuation multiple goes down. This determination has an inverse correlation to the earnings or price multiple figured for the similar asset.
The cap rate is usually calculated with the use of the property’s current price in the market over a particular timeframe.
Once the market price remains stable, no changes will happen to the rate. But, the moment the prices go up or down, there will be a change in the rate.
Since the property owner cannot, in any way, control the market prices, the sole variable under the control of the owner is the NOI or net operating income.
This is why the owner should look for a way on how to increase the net operating income to keep up with the increasing market price.
Just as expected, it is more favorable to have a higher cap rate instead of a lower one.
It means that as the values in the market change, business owners should always be on top of the income they get from the asset where they put their investment to get rates that work in their favor.
What is a Good Cap Rate?
What is a good cap rate, then? The simple answer here is that it will depend on how you use the cap rate.
If you want to sell a property, for instance, a lower cap rate can be considered as good since this indicates that your property’s value is going to be higher.
If you will buy a property, on the other hand, a good cap rate is a higher cap rate since this means that you will have a lower initial investment.
You are also probably looking for a market-based cap rate with the use of the recent sales of similar properties.
For such cases, a good cap rate is a cap rate derived from comparable properties in the similar location.
Say, for instance, you want to determine the worth of an office building according to the market-derived cap rate.
Here, a good cap rate is something that has been derived from the latest sales of office buildings within the same market.
Meanwhile, a bad cap rate is one derived from the different types of properties in the different markets.
How Do You Calculate Cap Rate?
The cap rate can be calculated with the use of the latest sales prices of similar properties and the net operating incomes.
The cap rate is then determined and applied on the property you are planning to buy to know its present market value according to the income.
For starters, you should get the latest sales price of the comparable income property. This example will use an apartment building with 6 units sold for a price of $300,000.
Next, you have to identify the apartment building’s net operating income or its net rentals realized by its owners.
Deduct all of the operating expenses but don’t include the mortgage.
The calculation will value the property like you paid for it in cash. After all the deducted expenses, say that the rental income is $24,000.
Then, divide this net operating income by the property’s sales price to determine the cap rate.
That is, expenses of $24,000 divided by the sales price of $300,000 will give you the cap rate of 8% or 0.8.
What Factors Go Into Cap Rate?
Different investors perceive bad or good cap rate differently. Different cap rates can be observed among various types and categories of commercial and residential real estate.
But, there are several key factors that go into cap rate, and these include the following:
Asset class
This refers to the specific type of property like apartment building, multifamily, commercial or industrial property. Residential properties often have lower cap rates compared to commercial properties since commercial properties often have higher rents.
Location
The location of the property drives demand and affects the local economy. In general, a location that is more desirable means higher rates and higher fair market value of the property. The capitalization rate often remains unchanged.
Interest rates
Increasing rates often means a decrease in the values of the properties. Once the rate increases, debts generally increase as well, decreasing the net cash flow. It means that increasing rates will result to lower cap rates.
Available inventory
It refers to the number of properties that are available in an area. Most of the time, when the inventory is lower, the demand will be higher, resulting to properties that have lower cap rates.
How Property Type Affects Cap Rate
When investors decide where they should put their investment in, they normally check the specific type of the property.
Properties could be residential, retail, office, or industrial and all of them have an impact on the investment.
For instance, STNL or single tenant net lease properties are usually safe investments with stable cash flow, not to mention that they are also safe for the investors.
Rental or residential properties require constant maintenance and there are times when vacancies can occur that can jeopardize the income you get from the property every month.
With a retail, STNL, or net lease property, you typically have a tenant who stays for a long term in the space, has reliable income source and corporate guarantee at times.
Investments that have low risk are good investments you can add to your portfolio.
It also means that the cap rate is affected by the risk involved.
How to Use Cap Rate for Real Estate Investing
The cap rate is among the most extensively used metrics in real estate investing to measure the profitability or return on investment of an income property.
The cap rate is a critical metric for real estate investors because this offers a way to measure the rate of return no matter what the financing method for the investment property is, whether a mortgage loan or cash.
Simply put, the cap rate is completely dependent on income property instead of the property investor.
The cap rate is also correspondent to the risk level associated with a real estate investment property.
It means that a low cap rate corresponds to lower level of the associated risks while high cap rates are correspondent to higher level of the associated risks.
In general, as far as real estate investing is concerned, a higher cap rate is better for a property investor.
Why is that?
This is because as far as any form of investing is concerned, such as real estate, the lower risks are going to yield lower profitability and higher risks are going to yield higher profitability.
What is a Good Cap Rate for Rental Properties?
What is a good cap rate for rental properties? Once again, the answer is that it will depend on how you will use the cap rate. A good cap rate is a concept that is more subjective instead of objective.
Cap rates and risk have almost become synonymous.
Therefore, to know a good cap rate for a rental property, first, you need to identify the amount of risk you find comfortable to expose yourself to.
Different cap rates have different risk levels. A low cap rate implies lower risk while a higher cap rate implies a higher risk.
This means that you don’t really need to know what a good cap rate is.
Instead, you should know the right cap rate that corresponds to the risk level that you think you can tolerate.
The cap rate for an investment property might sound simple yet it has heavily weighted implications.
After all, an investor who can reach an accurate estimation of the cap rate of a property rate will have a better chance to achieve success.
For example, putting your investment in a treasury bond good for 10 years is going to be an ideal fit for an investor who wants a more passive and more stable experience.
Meanwhile, an investment in a class A building that has several tenants is a great fit for investors who lean more on their entrepreneurial side.
There are bigger potential returns if things go well.
However, it also comes with the potential for much lower returns or worse, even losses.
In general, a cap rate falling between 4% and 12% is common and regarded as a good cap rate.
But, once again, it will still depend on the area’s available inventory, the demand, and the particular type of property in question. A good cap rate is always subjective and different real estate investors with different investing techniques look at it in a different way.
What is the Formula for Cap Rate?
The formula for capitalization rate is equal to the NOI or net operating income divided by the asset’s current value in the market.
Cap Rate = Net operating income/current market value of the asset
Here, the net operating income refers to the yearly income that the property generates after deducting all the expense s incurred from the operations that include the paying taxes and managing the property.
Meanwhile, the asset’s current market value refers to value of the asset in the marketplace.
What is a Good Cap Rate for Apartments?
Identifying what a good cap rate is if during your search for apartments is still a quite subjective undertaking.
But, if you want to get a general answer that is going to serve you better, it is recommended that you search for apartments whose cap rates are double digits.
At least, you would also want to buy an apartment that offers value increasing opportunities to let you quickly increase the going in capitalization rate and turn it into double digits as fast as possible.
Most investors require a minimum of 10% cap rate before they even consider visiting a commercial property or buying it.
Also, it is important for you to remember to rely completely on the apartment cap rate or other commercial property cap rate so that you can identify the value. There are still a lot of things that go into identifying the value aside from a good cap rate alone.
Do You Want a High or Low Cap Rate?
An investor who is planning to buy a real estate investment property will generally want to have a higher cap rate.
This means that the purchase price or value of the property is going to be relatively low as compared to the net operating income.
But, a seller might want to have a lower cap rate since it indicates that the price of the sale is going to be higher.
The Bottom Line with Cap Rate
Now more than ever, investors have realized the importance of using a cap rate as the tool that can help them in the evaluation of the piece of a real estate property. This is depending on the current fair market price and the net operating income.
The formula for cap rate is being used to determine the possible rate of return on an investment in real estate.
The idea of a good cap rate is dependent on many factors because this concept is subjective instead of objective.
This will differ depending on the investor, the type of property in question, and numerous other important factors.