What Is A Cap Rate And Are Cap Rates Important?

What Is A Cap Rate And Are Cap Rates Important?

In the Real Estate world the word “capitalization rate” also known as “cap rate” is well known. Cap rates measure the rate of return on an asset without taking into account the debt on the asset. They can be an important tool but can also be deceiving to an investor who is just starting out, not knowing what the cap rate does and how to use it can hurt the investor. The net operating income (NOI) divided by the price of the asset is how you get the cap rate. If you had an asset worth $500,000 and it had a net operating income of $43,000 per year then the cap rate would be 8.6% (500,000/43000=.086).

Cap rates can help you compare different properties and can help you measure risk but they should not be the only factor you should use when investing and at times they can be a bit useless. You may be wondering how cap rates can be deceiving. Let’s say you were looking at two identical multifamily units.

Complex A is located in Charlotte and was built-in 2015, it is in perfect condition and has an occupancy rate of 96%. The property is worth $1,000,000 and has an NOI of $78,000 per year which brings the cap rate to 7.8%.

Complex B is also located in Charlotte, built-in 2015. But unlike complex A, complex B needs a little touch up to the property and has an occupancy rate of only 80%. Complex B is also worth $1,000,000 and has an NOI of $73,000 which brings the cap rate to 7.3% which is lower than complex A.

If you heavily relied on the cap rates of both properties and you chose complex A, you would’ve missed out on the deal on complex B. While complex B has a lower cap rate, the property is a “value add” property. This is key because investors can make money on the buy. The investor can fix up the property to increase the value, this is called “forced appreciation”. Let’s say you buy complex B and fix it up for $50,000 and is now worth $1,200,000 and has an NOI of $73,000. You now have added $150,00 of value to that property. The property now has a cap rate of 6% if it is valued at $1,200,000. But you also noticed how complex B was mismanaged and only had an occupancy rate of 80%. Let’s say you raise the occupancy rate to 96% and your NOI is now $92,000 which brings the cap rate up to 7.6%. While the cap rate is still lower than complex A by .02% its still the better investment because you put in 1,050,000 into the property ($1,000,000 for the property and $50,000 for renovations) and are now bringing in an NOI of $92,000 which makes your cap rate 8.7%. You made $150,000 on the buy and are now making $12,000 more per year compared to complex A.

Notice how when you first began looking at the two properties, if you only looked at cap rates you would’ve picked complex A and missed out on the better deal. This example should show you that investing in real estate is not all about the cap rate. There are many other factors when investing in real estate and if you only focus on one single factor like the cap rate, your time in the Real Estate Investing World will be short-lived.