If you are a real estate investor, you know how big a task it is to find good deals on investment properties. When you start to grow your holdings, you require a sophisticated system based on metrics to figure out which property is a winner. The capitalization rate (cap rate) is one of the metrics very significant to real estate investors, who use it to help evaluate properties and find good deals.
Capitalization rate (or Cap Rate for short) refers to the rate of return on a property based on the net operating income (NOI) generated by that property. In other words, the capitalization rate is a return metric used to determine the potential return on investment or payback of capital. It can be calculated through a formula for cap rate in real estate.
The cap rate is the most widespread measure through which real estate investments are evaluated for their profitability and return potential. The cap rate apparently represents the profit of a property over a year's time, assuming the property is purchased on cash and not on loan. In the real estate market, Cap Rate is used to find the potential return for investors on their investment.
In simpler words, the capitalization rate is used in the orb of commercial real estate to predict the rate of return expected from an investment property.
While the cap rate is valuable for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength. Because it does not take into account other factors like time, the value of money, and future cash flows from property improvements.
There are several versions that exist for the computation of the capitalization rate. But, in the most popular formula, the Cap Rate is equal to the Net Operating Income (NOI) of the asset divided by its current market value.
It is the annual income generated by the property after deducting all expenses incurred from operations, including managing the property and paying taxes.
Net Operating Income = Gross income – expenses
The current market value is the value of an asset in the marketplace.
Annually calculating the cap rates will allow us to know what properties are or aren’t performing. Let’s walk through to understand this formula better.
First, let us learn how to compute the net operating income (NOI). The NOI is the sum of the property’s income flows minus the sum of the property’s expenses.
Property’s income flows can include any form of income it can produce, such as rental income, fees, and onsite amenities that require additional fees.
Next, we will add up the property’s expenses. The obvious ones to include are property taxes, insurance premiums, repairs and legal costs. However, some less common ones should also be included, like potential vacancies. Though most investors consider an average of 10% vacancy, it is always advisable to do some research in the local area to determine an accurate estimation of the property’s expected vacancy rate.
Once we have the property’s income and expenses, we can subtract the costs from the earnings to determine the NOI.
When we talk about current market value, it is critical to note that market value and the price paid is not necessarily the same. Value means what the property is raised for, which can change over time and is often inclusive of different values depending on the investment.
On the other hand, the price is what an investor pays for the property. Price may include additional costs which are not reflective of the asset’s underlying value, like closing or releasing fees.
The current market value of a property can be figured out by checking out the property details or by exploring home valuation estimation tools available in the market.
However, the final step is to convert the result of the division into a percentage. It can be done by simply multiplying the result by 100.
The capitalization rate is beneficial when it comes to comparing different investment opportunities in the real estate business. If all other parameters are kept equal, and the property with a 10% cap rate is compared with another property with a 3% cap rate, then an investor is most likely to focus on the property with a higher cap rate (10%). This rate also indicates the time it takes to recover an investment in a property. For example, if a property comes with an 8% cap, it will take eight years for the investor to recover his investment.
Although it is a crucial metric in comparing investment opportunities, investors should never base a purchase on the cap rate of a property alone. It is essential to note that different cap rates also represent different levels of risk – while a low cap rate implies lower risk, a high cap rate implies higher risk. Therefore, there is no "optimal” cap rate – it depends on the risk preference of an investor. However, cap rates that fall between 4% and 12% are considered the "good cap rate".
Undoubtedly, cap rates can provide valuable insight into a property, but this cannot be the only metric used to evaluate a real estate investment. While investing, investors will also want to consider the return on investment (ROI), internal rate of return (IRR) and gross rent multiplier (GRM), as well as a variety of other factors, including the individual characteristics and location of the property.
Assume that Mike has $1 million and he purchases a commercial building. This building has multiple tenants who are expected to pay regular rent.
In the second case, assume that the total rent received per year is $80,000, and the investor needs to pay a total of $20,000 towards various maintenance costs and property taxes. It leaves the net income from the property investment at $60,000. Suppose the property value remains steady at the original buy price of $1 million for the first year.
Then through the cap rate formula calculator, the capitalization rate will be computed as (Net Operating Income/Property Value) = ($60,000/$1 million)*100 = 6%.
This return of 6% generated from the property investment is better than the standard return of 3% Mike could get from regular bonds.
Property investment is risky, and there can be many scenarios where the return, represented by the capitalization rate measure, can vary widely.
For instance, a few tenants may move out, so the rental income from the property may diminish to $35,000, and reducing the $20,000 towards various maintenance costs and property taxes and assuming that property value stays at $1 million, the capitalization rate results ($35,000 - 20,000 / $1 million) = 1.5%. This value is significantly less than the return from the other investment sources available in the market.
In another scenario, imagine that the rental income stays at the original $80,000, but the maintenance cost or the property tax increases significantly, to say $50,000. Then the capitalization rate will be ($80,000-50,000/$1 million) = 3%.
Now assume that the current market value of the property diminishes, to say, $800,000, with the rental income and various costs remaining the same, then the capitalization rate will increase to $60,000/$800,000 = 7.5%.
Hence, the capitalization rate significantly depends upon the income generated from the property, expenses related to the property, and the current market value of the property.
You use the cap rate to influence your investment decision, but one cannot deny that many factors can impact the cap rate. A few aspects to consider include market, location, and property type.
Let us have a look at the factors that can have a noticeable impact on cap rates:
Of course, these are not the only factors that can influence cap rates, but these could make an extensive impact.
Hope this article gives all your answers to the questions of what is the cap rate for real estate, how to calculate it, its importance and the factors affecting the cap rate. And you can always learn more through this educational and informational course .
A complete guide about cap rates. In-depth knowledge of cap rate formula, its calculation, importance of cap rate, and factors influencing cap rate.
In this article, you will get all the understanding of capitalization rate, cap rate formula and its calculation, importance and examples of cap rate, and the factors impacting cap rate. This guide will help every real estate investor.
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