There’s much debate when it comes to determining what capitalization rates (cap rates) to look for when making a real estate investment.
“Find investments that offer a high cap rate so you make more money.”
“Find investments that offer lower cap rates so you have less risk.”
“High cap rates are great for buyers; low cap rates are great for sellers.”
“Don’t worry about cap rates when investing because they don’t really tell you anything anyway.”
So what’s all the buzz about?
Good question. Before we go too far, let’s make sure everyone knows what we are talking about when we talk about cap rates. The cap rate is a formulaic way to determine an investment’s value.
Cap Rate = Net Operating Income (NOI)/Current Market Value
So you may be told to invest in a property with a high cap rate because you will make more money. True. If you acquire a property for $500,000 with a cap rate of 10%, then you can expect to make $50,000 annually. However, some people might tell you that such a high cap rate means that you are investing in a significant amount of risk since it is typically only properties that have higher potential for vacancies or lower credit-rated tenants, etc. that can produce such a high cap rate.
In contrast, if a different property acquired for $500,000 with a cap rate of 6.0% earned you $30,000 annually, you might have a more secure investment that may more likely continue to produce that $30,000 more consistently for a longer period of time.
The warning some advisors give about cap rates is that the cap rate determined at the time of purchase can be misleading if any errors were made in the calculation of the annual income. Furthermore, cap rates don’t factor in debt on the property. Therefore, you can’t depend solely on the stated cap rate to indicate how much annual income you will earn. Mortgage payments will reduce annual income below the cap rate expectations. And cap rates are constantly changing as the market value of the property changes. An attractive cap rate at the time of purchase can quickly become an unattractive cap rate if the market is volatile.
For some investors, the cap rate becomes irrelevant after the property has been purchased. These investors are interested in sustaining the expected annual income and are not concerned with the market value of the property. For other investors, the change in cap rate remains extremely relevant as the investor looks to the cap rate as an indicator of a good time to sell the property. A fall in cap rate can reveal a rise in the property’s market value and larger gains for the investor at the time of sale.
So back to the question: What cap rate should you look for when acquiring investment real estate? Well, if you hadn’t noticed, there’s no one answer for every investor. You will have to work with your advisors and consider your individual investment goals to determine what cap rate is suitable for you. Then you’ll have to look at the local market of each property to determine if the cap rate can reliably set your expectation for annual income and future property value.
Cap rates can be a helpful tool to help you identify a valuable investment. Call us at 1031 Crowdfunding, and we can help you understand the cap rates of our Delaware Statutory Trust (DST) offerings.