High Cap Rates, Low Cap Rates, and Successful Real Estate Investing
Using Cap Rates to Make Informed Real Estate Investing Decisions
By Rusty Tweed
Don’ t be fooled by the simplicity of the cap rate, or capitalization rate— this simple calculation can reveal a trove of insight on potential real estate acquisitions. Some have even argued that this number is the single most important metric for any budding real estate investor to understand.
Our guide makes it easy to wrap your head around cap rates and use them to your advantage. So, without further ado, let’ s jump in and learn.
What Can a Cap Rate Tell Me?
In a nutshell cap rates provide a quick and simple way to help get a feel for a property’ s overall investment potential and a balance with the property’ s levels of risk and return on investment. To better understand how to achieve this, we’ ll look at a few examples.
Cap Rate Formula: How to Calculate Cap Rate
The cap rate formula is simple: Divide net operating income( NOI) by the property value( or the purchase price).
Cap Rate = Property’ s Net Operating Income / Property Value( or Purchase Price)
We can find net operating income by subtracting the property’ s annual expenses from its annual gross revenue. Expenses will include things like operating expenses, management, taxes, and anything else you must pay to keep the property running.
Careful though— debt payments, capital expenditures, and depreciation deductions are NOT included in the calculation. This is because we are trying to get a sense of the property’ s performance irrespective of any mortgage arrangements, improvements we might make or depreciation schedule that may be selected.
For revenue or cashflow, you’ ll simply plug in what tenants currently pay in rent( total rental income), as well as any other sources of income( Ex: a laundromat or a parking garage).
Should I Use Market Value or Purchase Price as my Denominator?
For the bottom of our capitalization rate fraction, market value is generally preferred. A purchase price can be used if the property
has sold recently, but using a purchase price from ten years ago won’ t result in a meaningful cap rate. If we are considering purchasing the property, it would be very useful to plug in various possible purchase prices to see what rate we’ ll achieve. This can be a helpful guide when determining an acceptable offering price.
Here are some examples:
Suppose you’ re an investor considering buying Property A. The property is valued at $ 1,000,000 and generates an NOI of $ 50,000 annually. Plugging this into our equation we get:
Cap Rate = $ 50,000 /$ 1,000,000 = 5 %
Suppose you compare Property A to a similar property that is valued at $ 1,000,000 and has an NOI of $ 60,000. This gives us a Cap Rate of 6 %. If all else between Properties A and B is equal, the higher cap property is the better buy.
Investors can also think of cap rate as a measure of their rate of return on their investment. For example, with the 5 % rate, an investor earns 5 % of their purchase price annually and will recoup the purchase price in the 20 years.
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