Cap Rates

The world of real estate has a lot of vernacular that may be foreign to a person that is new to this arena, including cap rates, REIT, ROI, and more. Capitalization rates (or “cap rates” for short) is a very common one, which we will review below.

A cap rate is one of the most commonly used metrics to evaluate real estate and reflects the expected rate of return on a property for sale. The expected rate of return is the net gain or loss of an investment over a specific period of time and is shown as a percentage of the property’s value. In short, it reflects how profitable the property is expected to be in relation to how valuable it is on the current market.

How is it calculated?

The cap rate is calculated by dividing the property’s net operating income by its current market value. That ratio is then expressed as a percentage.

(NOI / Fair Market Value) x 100

The NOI is the property’s income less its expenses. Note that the mortgage debt service (loan payments) are not included in this formula, which is important since this means this calculation is focused on the property alone and not affected by any financing. Since any investor could have a different combination of down payment and interest rates, this formula excludes those variations from the result. That’s one of the reasons this formula is so handy and popular.

How is it used?

Cap rates are a great tool you can use to compare properties. If you are looking at two properties available for sale at two different prices and values, it can be difficult to identify which would be the better investment. Calculating and then comparing the cap rate of the two properties gives you a better idea of which property will return your investment faster.

You can also use cap rates to compare your property to the market. Cap rates for the various metro markets are published by large investment firms such as CBRE each year and are available online. Comparing the cap rate of your property to the market will show you how well your property is performing versus the market standard. Cap rates are also published for the various property classes within the metro markets, so you can compare you property to the standard at a more micro level. In addition, cap rates are available at the property type level, which should be considered when doing your evaluation.

Cap rates are used as a measurement of risk. Lower cap rates indicate lower risk while higher cap rates indicate higher risk. Conversely, lower cap rates also indicate a lower level of return, while higher rates indicate a higher level of return.

Example

Let’s say you are looking at two properties. Both are the same type (i.e. self-storage) and both are in the same metro area (i.e. Houston). One is a solid B while the other is less than a solid B and more like a B-.

Property 1

  • $100,000 annual income (rents)
  • Less $40,000 annual expenses (electric, taxes, insurance, maintenance, repairs, etc.)
  • Equals $60,000 net operating income
  • $900,000 is the current value
  • 66% cap rate ($60,000 / $900,000)

Property 2

  • $75,000 annual income (rents)
  • Less $20,000 annual expenses (electric, taxes, insurance, maintenance, repairs, etc.)
  • Equals $55,000 net operating income
  • $850,000 is the current value
  • 47% cap rate ($55,000 / $850,000)

Initially, it looks like property 1 is the better purchase. You know you can add value to property 2 by implementing various property improvements, and you see room to increase the rental rates. You estimate that the cost of this would be $100,000.

Property 2 (revised)

  • $105,000 annual income (rents)
  • Less $35,000 annual expenses (electric, taxes, insurance, maintenance, repairs, etc.)
  • Equals $70,000 net operating income
  • $850,000 is the current value + $100,000 = $950,000 new value
  • 36% cap rate ($70,000 / $950,000)

The improvements will take time, and there is more risk associated with the changes. But if you are confident that you can execute the plan, it would be worth it to purchase property 2.

Conclusion

In the end, cap rates are an important tool in the real estate evaluation process, and one that you should look at during any purchase. However, it isn’t the only tool or metric, and you shouldn’t rely solely on it.