As a real estate investor, you must understand all the figures associated with a property. Cap rate is one of many numbers you may see when looking at properties for sale, and it may guide your next investment decisions.
The Cap Rate Debate
There’s much debate when it comes to determining what capitalization rates (cap rates) to look for when making a real estate investment.
You may hear any of the following advice or arguments about cap rate for real estate investors:
- “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.
What Are Cap Rates?
Capitalization rate or cap rate is the expected rate of return on a property. It’s a formulaic way to determine an investment’s value.
This rate is calculated based on the net operating income (NOI) a property generates divided by the asset’s current market value.
Cap Rate = Net Operating Income (NOI) / Current Market Value
Essentially, the cap rate can give buyers an idea of what the return on investment (ROI) may be for a property.
Determining the Right Cap Rate
Every investor has different goals, so there is no one answer regarding the right cap rate.
When you begin searching for properties, your cap rate target will depend on your individual investment objectives. For some investors, cap rate becomes unimportant after purchase because they only want to sustain the expected annual income. For other investors, the cap rate is a helpful tool for determining when a property is worth selling.
A general rule to keep in mind is that a higher cap rate often comes with higher risk. If you buy a property for $700,000 with a cap rate of 10%, you can predict $70,000 annually. However, various scenarios can cause higher cap rates, such as the property’s location, the potential for growth, and asset stability. There’s no guarantee you’ll earn that full $70,000 every year.
In contrast, a property acquired for the same value of $700,000 with a cap rate of 4% can earn $28,000 annually. While these annual earnings are smaller, they’re likely more sustainable than the property with a 10% cap rate. Lower cap rates typically have a lower risk, allowing you to protect your existing wealth even though your cash flow is small.
You may be able to expect that $28,000 annually for years. While this amount isn’t nearly as high as the higher-risk property, consistently earning $28,000 a year may lead to more significant gains in the long term.
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 Rate Warnings
It’s essential to note that cap rates are more of a tool than a foolproof method for determining your ROI. Sometimes, the cap rate can involve calculation errors that don’t offer a fair picture of a property’s potential ROI.
Cap rates also do not factor in debt on the property, which will significantly influence your ROI. 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. If you take out a mortgage on a property, the cap rate will not fully encompass how much you’ll earn from the asset.
Another vital consideration is the stability of the market. 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.
When property values are particularly high in a given year, the cap rate can fall compared to the NOI. Since these values are subject to change at any given point, you should not treat them as a north star for your investment strategy.
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