What is a cap rate and why are they important ?
Rental Property Investor · Member since 2020 · 46 posts · 29 votes
I hear the words “Cap Rate “ a lot. What is a cap rate and why re they important? Is it something added onto a loan interest rate or maybe equity in a property? What is a good cap rate?
Cap Rate, or Capitalization Rate, is the expected return on a commercial real estate asset if there were no debt on the property. For example, a property that was purchased for $1 million with no debt, produces Gross Revenue of $200,000 per year, the annual expenses are $100,000, leaving an annual Net Operating Income of $100,000 (Gross Revenue - Expenses). Divide the NOI, $100,000, by the purchase price, $1 million, and you get a Cap Rate of 10% (NOI / Purchase Price). Meaning you can expect a 10% return on your investment of $1 million.
Cap Rate can also be looked at as a function of risk. Investors expect a higher return for investments that are riskier in nature. If you purchase that same property above for $800,000 and it produces the same NOI, it's Cap Rate is now 12.5%. That might sound better, higher return is always better, right? Not necessarily. The purchase price might have come down because the market views the property as over priced.
Cap Rates are often effected by the interest rates. As interests fall, Cap Rates often fall as well, because investors are able to borrow money at low rates, because it theoretically lowers their risk. As interest rates rise, Cap Rates often rise as well.
The power of the Cap Rate can be seen when you start to discuss value-add opportunities.
For example:
Let's say I purchase that property for $1 million dollars at a 10% cap rate. Through a mixture of increased revenue and lowering expenses, I increase the NOI to $125,000 annually. Divide that new NOI by that 10% Cap Rate and that $1 million property is now worth $1.25 million. Not only did I increase the potential cash flow by $25,000 annually, I increased the value by $250,000. Now, if doing all of the above also made the asset seem less risky to other investors, they might think it's more of an 8 Cap now (8% Cap Rate). In that case, the property is now worth $1,562,000.
It cuts both ways though, let's say all of the above is true, but we have a sudden rise in interest rates that pushes the market Cap Rate to 12%. Now, that property, while we have increased the NOI by $25,000, is only worth $1,041,666.
There really is no way to determine what a "good" Cap Rate is because it depends on the investor's business plan, their goals, and their risk tolerance.
In self-storage, an A Class facility in a Primary Market (think multi-story, full climate controlled, in a city like Phoenix) might be considered a 5 cap. While a C Class facility in a Tertiary Market (think single-story, over 20 years old, gravel driveway, in smaller town), might be considered a 10 cap.
Again, it's largely a function of risk. Typically, the higher the Cap Rate, the higher the risk, but the higher the potential return.
Personally, I like to look for a Cap Rate that is at least 2% higher than the interest rate at which I am able to borrow, with a significant value-add opportunity.
@Isacc Lightbourn
Cap rate is a way to find out the profit you could potentially make from a deal it is the net operating income divided by the purchase price
@Isacc Lightbourn there are a lot of replies to your question. I would offer a different angle on your question. (My overall opinion on cap rates aligns with @Steve Morris) I think you should be asking yourself "What are my goals for real estate investing?". Once you've determine your goals I believe you will need to select the appropriate metrics / key performance indicators that tell you whether you are achieving your desired goal. I all together ignore cap rates and focus more on cashflow per door and internal rate of return as my key performance indicators. These metrics tell me whether I'm achieving my goals of positive cash flow and long term return on investment.
I hear the words “Cap Rate “ a lot. What is a cap rate and why re they important? Is it something added onto a loan interest rate or maybe equity in a property? What is a good cap rate?
I didn't read the whole thread. So, this may duplicate someone else's answer ...
Cap Rate - short for Capitalization Rate - among other things tells how quickly a commercial investment will pay for - Capitalize - itself. The lower the number the faster the payback. Also, the higher the number the less cash it produces before debt service.
Just another perspective ...
Although I don't see cap rate as a payback metric, this seems backwards to me.
Lower cap rate takes slower NOT faster to payback, doesn't it? Shouldn't higher cap rate produce more cash NOT less to service debt?
Cheers... Immanuel
Yes! You're quite right. I was thinking of something else. Thanx for noticing.
@David Dachtera you weren't wrong.......if your selling. Selling at the lower cap would pay back any debt a lot faster lol! GRM when lower indicates faster payback, but of course just one small metric to be used! Everyone has their formulas and due diligence that makes sense to them. That's what makes real estate so great, the fact you can tackle in many different directions. Have a great night!
Hi Isacc, Cap Rate is what you would yield/return if you purchased a property with straight cash / all equity. You can find a more accurate return on equity figure if you take the cap rate applied to the total asset value (purchase price + renovation + closing costs) and then subtract debt service to find your net cash flow. Then divide that by your equity to find your return on equity.
Back to Cap Rate and net operating income for a moment. Two rules of thumb to keep in mind are that your Net Operating Income will typically be 60%-70% of your top line depending on the market and that your tax bill should be half of your operating expenses.
With that being said, every deal is unique and each property is a case by case. A few items to consider:
(1) Taxes - The opportunity to appeal exists. NY does a one way appeal, so you can fire off your appeal with no consequences and you might get lucky. Other states (like NJ) could be opening Pandora's box and your tax bill could also go up upon appeal
(2) Utilities - Are they separately metered? If not, can you create tremendous value by doing so?
(3) Water - Typically paid by the landlord, but pay attention to any leaks or inefficient fixtures (i.e. old shower heads, toilets, etc.)
(4) Insurance - The world of insurance is vast. Shop around! Prices fluctuate rapidly as do levels of coverage.
(5) Maintenance and CapEx - Typically, they say you should budget 3% to 5% for each (as a % of rent) but that is a bit of a silly rule. Rents can be highly variable, the cost of a broken furnace is not. I'd think about this in terms of hard numbers. Perhaps $1,000 per unit per year. You can drop that to $500 if you have a larger property which can be managed more efficiently or if systems were recently updated.
(6) Grounds/Snow Removal - Is this a two family where you can make the tenants responsible for shoveling their driveway or a 12 unit with a parking lot? Very different situations.
Happy to chat further anytime