Property investors new to the real estate arena are often overwhelmed by the seemingly complex calculations, and terms experienced property investors are well-accustomed to. One of the most critical calculations for any property investor is, without a doubt, the capitalization rate. It is a wondrous thing indeed. The number generated, which signals the demand for the property and the feasible range of prices among other things. Without further ado, let’s get well-acquainted with the North Star for any property investor out there—the capitalization rate.
Capitalisation Rate 101:
Let’s break down the capitalization rate to something more comprehensible than technical jargon. For the layman, the cap rate is the potential rate of return on your investment based on your estimate of how much income the property will generate. This is an important factor, considering that the intention is to make money, not to potentially lose it while flying blind.
LET’S DO THE MATH
Definition: Mathematically, the capitalization rate is the ratio of Net Operating Income (NOI) to property asset value. It represents the percentage return an investor would receive on an all-cash purchase.
Cap rate can be calculated using the net operating incomes and recent sales price of comparable properties. Let it be noted that cap rate measures a property’s yield in a one-year time frame without taking into account any debt on the asset.
Consider a property recently sold for $1,000,000 and had a stabilized net operating income of $100,000. In the commercial real estate industry, we say that the property sold at a cap rate of $100,000/$1,000,000, or 10%.
Calculate the annual gross income of the property.
Having bought a property, the real estate investor primarily makes money from it by renting it out. The annual gross income is mainly regarding these rent rolls tenants pay.
For example: If an investor intends to charge $700 per month, he/she can expect to have a gross yearly income of $(700 x 12) = $8400.
Subtract from the above all reasonably necessary operating expenses.
In order to calculate the net yearly income of the property, subtract the operating costs from the gross income. These operating costs are in the form of maintenance, insurance, taxes, utilities, vacancy costs, and property management. It does not include depreciation or property’s business expenses – including the purchase costs of the property, mortgage payments, fees, etc. since these reflect the debt of the investor.
For example: If we can expect to pay $700 in property management, $450 in maintenance, $610 in taxes, and $550 in insurance per year for our property, the net operating income (or net yearly income) is $ (8400 – 700 – 450 – 610 – 550) = $6090.
Divide the net operating income by the property asset value (the purchase price).
Assuming we purchased the property for $ 71,000. Then the cap rate is 8.6%.
WHYs and HOWs of using CAP Rate
So the importance of the cap rate, in theory, is all well and good, but when should I use it to help me? Does it guide my choice of property or does it enter the picture when the time for negotiations is upon me?
Well, the cap rate is as important as it is because it does both. Let’s see how.
The cap rate help determine which property investments should be pursued. Different geographical areas have different capitalization rates. The more demand an area has, the greater is its cap rate, and vice versa. The cap rate usually ranges from 4% to 10% and is an indicator of the investment-worthiness of an investment.
The cap rate can be used to compare similar properties because all expenses are taken into account in one of the metrics used i.e, net operating income. A property may have greater cap rate as compared to a reasonably similar one if it generates more income or has lower expenses. Hence, it helps further narrow down choices.
The cap rate helps determine if the property has a reasonable asking price. It can also help you negotiate to the price above which the property is not worth investing in. Some property investors also set minimum standards for investment.
For example, some prefer not to invest unless the cap rate is higher than 5%.
As an investor, one might also want to value property with the intention to sell based on market cap rates for other recently sold comparable properties.
WORD OF CAUTION
Yes, cap rates are a fundamental tool in evaluating the expected return on investment. They do help in comparing cash flow projections for narrowing down choices. They do seem to cover all loopholes by deducting operating costs. However, the cap rate is far from infallible in the real world when used alone. The cap rate does not account for the change in the value of the property or even consider the possible growth potential of the property in the years to come. Be advised against using it as the sole factor in making investment decisions.