What is a good cap rate on an investment: A cap rate, also known as a capitalization rate, is one of the most important fundamental indicators for determining whether a property is worth going after.
Unsurprisingly, cap rates have proven essential to building some of the most productive real estate investment portfolios, and there is no reason why this can’t help.
In fact, I’d say you can’t even build a halfway decent portfolio without asking yourself, “what is a good cap rate on an investment ?” It is so important.
Therefore, it is in your best interests not only to better understand the cap rate but also to know how to use it to boost your investment efforts.
Investing in rental properties can be an extremely lucrative business.
While the prospect of making a profit from renting real estate is exciting, the reality of real estate is far more complex than you might think.
If your math sucks, your investment sucks too. It’s that simple. While it doesn’t sound exciting,
it’s important to understand how to properly value rental property investments using the right calculations and tools.
Thus, you need to know what a good cap rate on an investment is.
If you don’t rely on the number and factor in all aspects of potential costs and rewards, you can expect a rude awakening and potential loss of your money.
For these reasons, it is important that you understand the pros and cons of the cap rate of a particular property in order to accurately determine its profitability.
Without further ado let’s take a closer look at cap rates and what they mean for real estate investors like us.
What is a cap rate?
A capitalization rate is one of the easiest and most reliable ways to quantify whether a property is worth investing in.
In its simplest form, a cap rate is nothing more than an equation; one that identifies what an investor stands to gain or lose by buying the property in question.
Real estate investors and other players in the real estate sector use the cap rate calculation to estimate the return on investment.
It should be noted, however, that a cap rate does not provide investors with the exact amount that they can make or lose from an investment, but rather an estimate.
Therefore, if you are talking about what is a good cap rate on an investment you should know that rates are no more accurate than stock market predictions;
they are subject to an inherent degree of error and should be taken with a grain of salt.
Again, the cap rates are not 100% accurate. They are only used to estimate the potential return on the investment.
However, a properly estimated cap rate is invaluable when backed by care and attention to detail.
Cap rates are not intended to act alone but should be used in conjunction with other parameters.
A cap rate in itself is almost useless, but a cap rate with additional data and information can significantly reduce the risk an investor is exposed to while investing.
To calculate the cap rate of a property, you simply divide the NOI by the value of the property.
What Is A Good Cap Rate For Rental Property?
It can be difficult to determine exactly what a good cap rate looks like. The answer to this question largely depends on the market you are in and the specific goals you have as an investor.
A good cap rate is four percent; however, it is important to distinguish between a “good” and a “safe” cap rate.
The formula itself sets the operating profit against the original purchase price. As a result, investors looking to do deals at a lower purchase price may want a high capitalization rate.
According to this logic, the capitalization rate between 4 and 10% can be considered a “good” investment.
However, capitalization rates have also become synonymous with risk assessment.
To determine a “safe” limit, you need to identify the risk that you are happy to expose yourself to.
In essence, a lower cap rate implies less risk, while a higher cap rate implies higher risk.
Investors hoping for a safer option would therefore prefer properties with lower capitalization rates.
The most important thing to remember is that you should never take more risks than you would like.
When Is Cap Rate Used And Why Is Cap Rate So Important?
The cap rate is used by investors deciding whether or not to purchase a particular property. In some cases, it can also be used by investors preparing to sell a property.
The cap rate is best for rental properties and may not be as useful in other scenarios.
For example, investors should avoid relying on the capitalization rate when valuing raw land, solid and returned property, and in some cases short-term rents.
In fact, the formula for the cap rate is based on annual operating profit, which would not be applicable in these cases.
However, investors (or even homeowners) can use the cap rate when valuing a number of types of property, including:
- Multifamily Rental Properties
- Apartment Buildings
- Single-Family Rental Homes
- Rentable Townhouses
- Commercial Real Estate
The cap rate is important as it can give an idea of the initial return on an investment property.
The formula relates the operating income to the purchase price of the investment, which can put the potential profitability of the transaction into perspective for investors.
According to Investopedia, the cap rate can also tell you how many years it will take for the original investment to pay for itself.
For example, it takes four years for a property to pay for itself at a capitalization rate of 4%.
Overall, the capitalization rate is an important way for investors to estimate the risk associated with a particular property.
How to Calculate Cap Rate: Capitalization Rate Formula
As important as cap rates are, they are not as complicated to calculate as you might think.
In fact, learning how to calculate cap rate requires nothing more than basic math skills or a free cap rate calculator.
However, before you start calculating your own cap rate, you need two things:
- The property’s net operating income (NOI)
- The amount it would cost to buy the property
Though, there are several versions for calculating the capitalization rate.
The most common formula calculates the capitalization rate of a real estate investment by dividing the building’s net operating income (NOI) by its current market value.
Mathematically,
Capitalization Rate = Net Operating Income / Current Market Value
Where:
Net Operating Income is the (expected) annual profit of the asset (e.g. rent) and is achieved by deducting all costs incurred in managing the asset.
These costs include the cost of regular maintenance of the facility and property taxes.
The current market value of the asset is the current value of the property at normal market conditions.
In another version, the number is calculated based on the original capital cost or the cost of acquiring an asset.
Capitalization Rate = Net Operating Income / Purchase Price
However, the second version is not very popular for two reasons.
Firstly, it gives unrealistic results for old properties that were bought at a low price a few years/decades ago,
and secondly, it cannot be applied to the inherited property as its purchase price is zero, making it impossible to calculate.
Because house prices fluctuate widely, the first version, which uses the current market price, is a more accurate representation than the second, which uses the initial fixed-value purchase price.
Examples of Capitalization Rate
For example, let’s say an investor has $ 1 million and plans to invest in either of the two investment options available.
First, it can invest in government-issued treasury bills that pay annual interest.
Nominally 3% and is considered the safest investment, and secondly, it can buy a commercial building with multiple tenants who should pay regular rent.
The second case assumes the total rent is $ 90,000 per year and the investor pays a total of $ 20,000 for various maintenance costs and property taxes.
The net income from the property investment is $ 70,000.
Assume the property’s value remains stable for the first year at the original purchase price of $ 1 million.
The capitalization rate will be computed as (Net Operating Income/Property Value) = $70,000/$1 million = 7%.
This 7% return on real estate investments is better than the standard 3% return on risk-free Treasury bonds.
The additional 4 percent corresponds to the return on the risk the investor takes by investing in the real estate market compared to investing in the safest treasury bonds that carry no risk.
WHAT DOES MEAN
Real estate investments are risky and there can be different scenarios in which the return, represented by the cap rate figure, can vary widely.
For example, some tenants may move out and rental income from the property may drop to $ 40,000.
If you reduce the $ 20,000 for various maintenance fees and property taxes and assume the property’s value remains at $ 1 million,
the cap rate goes down to ($ 20,000 / $ 1 million). = 2%. This value is lower than the available return on risk-free bonds.
Another scenario assumes that rental income remains at the original level of $ 90,000
but the maintenance fee and / or property tax increases significantly, for example $ 50,000.
The capitalization rate is then ($ 40,000 / $ 1 million) = 4%.
In another case, the cap increases to 8.75%. I.e. $ 70,000 / $ 800,000 = 8.75%.
When the current market value of the property itself drops to $ 800,000, with rental income and various costs remaining the same.
In essence, different levels of income from the property, expenses related to the property, and the current market value of the property can change the capitalization rate significantly.
The excess return theoretically available to property investors beyond investing in Treasury bonds
is due to the risks involved leading to the scenarios above.
Risk factors are:
- Age, location, and status of the property
- Property type – multifamily, office, industrial, retail or recreational
- Tenants’ solvency and regular receipts of rentals
- Term and structure of tenant lease(s)
- The overall market rate of the property and the factors affecting its valuation
- Macroeconomic fundamentals of the region as well as factors impacting tenants’ businesses
Interpreting the Capitalization Rate
Because the cap rates are based on projected estimates of future income, they are subject to a high degree of variance.
It then becomes important to understand what makes a good maximum rate on an investment property.
The interest rate also indicates the time it takes to get back the amount invested in a property.
For example, a property with a 10% cap rate will take around 10 years to recoup the investment.
Different capitalization rates between different properties or different capitalization rates
over different time horizons for the same property represent different levels of risk.
A review of the formula shows that the value of the cap rate is higher for properties that have a higher operating income and a lower valuation, and vice versa.
For example, suppose there are two properties that are similar in all attributes except that they are geographically separated.
One is in an upscale city center, the other on the outskirts of the city.
If all other things are the same, the first property will generate higher rent than the second,
but these will be partially offset by the higher maintenance costs and higher taxes.
The downtown building will have a relatively lower capitalization rate than the second due to its very high market value.
What doe this mean?
This indicates that a lower cap rate value corresponds to better valuation and a better prospect of return with lower risk.
On the other hand, a higher value of the capitalization rate implies relatively lower prospects of a return on real estate investments and thus higher risk.
While the above hypothetical example makes it easy for an investor to decide on downtown real estate, the real-world scenarios may not be that simple.
The difficult task of determining the appropriate capitalization rate for a given level of risk is the difficult task of valuing a property based on the capitalization rate.
Cap Rate Vs ROI
The main difference between Cap Rate and ROI is why both metrics are used.
As mentioned earlier, a cap rate is used to estimate the potential return on investment (ROI) of investors.
Even so, it’s not hard to see why many business owners confuse the two. On the surface, the two parameters are very similar;
They each tell an investor what to expect when making an investment decision.
It should be noted, however, that when analyzing a property investment, Cap Rate and ROI serve a different purpose.
Return on investment is meant to give investors an objective percentage on how much they can expect to make on a deal.
For example, ROI is typically expressed as a percentage, to estimate the investor’s potential return on his or her investment.
That way, investors can compare the ROIs of two completely different assets.
The return on an investment expressed as a percentage makes it easier to compare two individual assets, whether or not they are the same.
Investors can, therefore, compare the ROI of a three-month rehab with a 30 year buy and hold.
The cap rate, on the other hand, is used to compare similar property assets.
For example, a cap rate would be perfect for someone comparing the returns of two rental properties, but less than ideal for investors looking to compare a rental property with rehab.
Conclusion
A capitalization rate for investment property may seem simple, but its effects are heavily weighted.
Because of this, it’s important to expand your real estate education and ask questions like “What is a good cap rate?”
Because those who equip themselves with the best investment instruments such as cap rates have a better chance of being successful in the industry.
What do you think is a good cap rate for real estate? Please let us know your thoughts on good cap rates in the comments.