Evaluating whether or not a particular property is a good investment requires a calculated comparison with other investment opportunities. One of the most popular methods for calculating a financial comparison between investment properties is examining what’s called the Capitalization Rate, or “cap rate”, for each property. That said, there’s a common tendency to rely on calculating cap rates as the only factor when choosing a piece of real estate to invest in, but there are numerous other elements to consider beyond cap rates alone.
Let’s examine why cap rates are so important in real estate investing, how to calculate a property’s cap rate, as well as some of the key factors that could impact the cap rates of your investment properties. We’ll also cover some methods seasoned investors use to reveal hidden value in investment property opportunities that less experienced investors often miss.
Cap rates in the commercial real estate world are similar to using multiples for valuing stocks or other equities. The concepts are very similar:
Paying $20 million for a building at a 5% cap rate would generate $1 million of annual net operating income (or NOI) for the investor. Another example would be paying $5 million for a property that earns $1 million in net operating income, resulting in a 20% cap rate.
In the world of stock investment, purchasing a company for $20 million that had $1 million in earnings last year would provide a 5% yield on the $20 million investment.
Stock investors would refer to this as a 20-multiple, but most real estate investors would refer to this as a 5% cap rate. The formula is one divided by the multiple= the cap rate.
Note, there are no clear definitions of a good or bad cap rate because they’re largely dependent on the property and how it relates to the market in various nuanced ways. Generally speaking however, the higher the Cap Rate, the better the returns, and the more desirable the investment. With this in mind, let’s cover how to calculate cap rates to provide this financial aspect of property analysis.
Assume rental income remains at the current level of $100,000, but maintenance costs and/or the property tax increase substantially, say by $25,000, on a property that’s $1 million. The capitalization rate will then drop from 10% to 7.5%.
If the current market value of the same property declines to $500,000, but the rental income and other costs remain the same, the cap rate will increase to 20% ($100,000/$500,000).
Essentially, income levels, expenses, and the current market valuation of a property can significantly impact the capitalization rate in a variety of ways. This cap rate is what indicates to an investor whether or not the investment passes or fails their general rate of return criteria compared with other investment options.
Factors that may impact the cap rate of an investment property in various ways include:
Cap rates are based on projected estimates of future revenue, so they’re subject to high variance. Therefore, it’s important to grasp what constitutes a solid cap rate for the particular investment property you’re looking at.
Cap rates can also be used to reference the amount of time it might take to recover your original investment in a certain property. For example, a property with a cap rate of 5% would take 20 years for you to recover the initial investment.
The difference in cap rates between properties or across differing timelines on the same property reveals the different levels of risk on each investment. Cap rate values are higher for properties that generate more net operating income versus a lower valuation, and vice versa.
To illustrate this, let’s use two properties as examples, one in a high-end area and the other in an area just outside the city in a more rural area.
The high-end property will have a higher property value (and often higher expenses like taxes), which could result in a lower cap rate than the property on the outskirts of town with lower rents and a lower valuation.
Though cap rate calculation provides a critical financial evaluation tool for real estate investors, it shouldn’t be used as the sole factor when purchasing a piece of rental property.
One of the most significant blunders less experienced real estate investors make is taking cap rates at face value. Remember, cap rates are based on current rents—not the potential market rents. Wise investors evaluate real estate based on current cap rates along with their potential cap rates.
For example, an office building offered at a sales price that results in a 5% cap rate might really be a good deal if the main tenant, who’s currently paying lower than market rental rates, has a lease expiring next year and demand is strong for space in the area.
If rates can be increased to higher market rates once this lease expires, then the commercial property might actually be worth far more than cap rate calculations based on current rental income alone.
If you want to diversify your portfolio and increase passive income but hate the idea of calculating cap rates on every property you invest in, Saint Investment Group is here to help. We offer exceptional commercial properties for real estate investors seeking solid returns and stable income streams without the need to crunch numbers daily.
Simply monitor fund performance with detailed monthly reporting and deal transparency, and enjoy earning passive real estate income with peace of mind. Call (323) 483-0291 today to learn how to get started.
A master in Investment, Marketing, and Capital Raising.
Nic has honed his focus on the Real Estate and debt markets with Saint Investment Group and pursues large-scale Distressed Asset purchases with his partners and syndications.