When you begin to delve into the world of real estate investment, the jargon will start coming at you fast and furious. One of the terms you will inevitably hear is “cap rates.” What do you need to know about cap rates, and how can you leverage this knowledge to realize a positive return on your investment?
Defining “Cap Rate”
Capitalization rate – or cap rates for us informal folks – is a common metric used by industry professionals to evaluate a property. It helps determine the return on your investment.
To understand cap rates you need to know two key terms:
Net Operating Income. NOI is all revenue from a property minus all reasonable operating expenses. NOI does not include payments and interest payments on loans, depreciation and amortization, and capital expenditures.
Property Asset Value. This is essentially the purchase price for the piece of property.
To determine the cap rate, you divide the NOI by the property value. For example, let’s say a property sold for $2,000,000 and had an NOI of $200,000. The cap rate would be: 200,000 ÷ 2,000,000 = 0.10, or 10%.
What’s a Good Cap Rate?
Your next question is, “What’s a good cap rate?”, isn’t it? We’ve got your answer!
It’s the worst answer, isn’t it! Cap rates should, ideally, correspond to the level of risk – and return. Lower cap rates typically indicate a lower risk level and vice versa. So, 10% is “better” than 18% or 20%.
But it is more complex than that, and cap rates are just one factor to consider. Let’s say that you’re interested in Property A, which has a cap rate of 15%. You keep searching and find Property B with the same NOI and a cap rate of 7%.
Go with A all the way, right? Well, what if A is an older apartment building and has high turnover, while B is a commercial building situated in a great neighborhood with long-term leases. B will have an higher appraised value, while A presents greater risk in terms of vacancy rates and likely upgrades/renovations.
Property A will cost less and provide an opportunity for higher return, while Property B will be more stable. There is no “right” answer. The best investment for you is one based on your needs, and in this case, your risk tolerance.
Property A and B were apples and oranges. Where cap rate is particularly helpful is when you are comparing apples to apples, that is, similar properties in similar locations. This allows you a quick glance at potential risk and return.
When investing in real estate, it is important to know about cap rates and how to use them. They can be a helpful tool, but they are not the only factor to take into consideration. Remember that it’s one piece of the puzzle and use it to make strategic decisions.