Investing in real estate can be a great way to generate extra income, but it can also be a huge drain on your resources if you don’t take the time to carefully examine the financials involved. There is always some element of risk involved in purchasing an investment property, which is why you want to ensure that the return on your investment – the amount of revenue you’re likely to generate from the property – is worth it.
To determine if a property is worth the risk involved in purchasing and operating it, real estate investors examine the property’s capitalization rate. A cap rate is a traditional method of measuring the value of investing in a specific real estate property. Although calculating the cap rate requires you to do some math, the formula is actually quite simple. If you’re thinking about investing in real estate, read this article to learn what cap rates are, how they work and when you should use them.
What Is A Capitalization Rate?
A capitalization rate – or cap rate – is a formula that allows you to determine the financial benefits of different investment properties. It enables you to weigh the income you would potentially generate in the first year of owning the property against the cost of purchasing the property. In this way, it can be thought of as the rate of return you’d receive on your investment.
The higher the cap rate of a property is, the higher the return on your investment will be. But like gambling, it’s the riskier deals that lead to higher returns. So, although properties with lower cap rates generate less revenue, they’re considered to be safer investments.
Keep in mind that cap rates are a more simplistic tool and should be considered a shorthand method for computing the value of investing in specific properties. Because of their simplicity, cap rates are frequently used by savvy investors in the real estate industry to quickly determine if a property is worth a closer look.
How Does A Cap Rate Work?
You can think of the cap rate as how you determine the value of a property based on its NOI. The NOI is the property’s net operating income – how much income the property makes.
To calculate the NOI, you must subtract the property’s gross income – the total revenue that the property generates – by the cost of operating the property. Operating costs include all of the property’s expenses, such as property taxes, insurance, utilities, repairs and maintenance, as well as administrative costs and management fees. A general rule of thumb is that all operating expenses for multifamily properties should be around 33% of the property’s annual revenue – but be sure to check as this rule varies by city and quality of the property.
You must also factor potential vacancies into the property’s expenses. Although there’s a chance that the property will be fully leased, vacancies play into the riskiness of investments and can cut into a property’s revenue substantially. So, you always want to err on the side of caution. Investors generally subtract a vacancy factor ranging from 5 – 15%, depending on the strength of the market.
Once you know the property’s NOI, you can calculate the cap rate by dividing the NOI by the current market value of the property. The current market value will be equivalent to the purchase price of the property because its value is dependent on what a buyer is willing to pay for it.
You’ll notice that one of the costs that is not factored into the NOI and thus not considered in the calculation of cap rates is debt and mortgage expenses. Cap rates treat each property as if it’s an all-cash purchase. The exclusion of financing in the calculation is important as it enables investors to judge properties based solely on their potential revenue and the extent of risk involved in the investment. Therefore, investors can more easily compare one property to another.
Breaking Down The Cap Rate
To calculate the cap rate of an investment property, you would use the following formula:
Capitalization Rate = Net Operating Income / Current Market Value of Property
So, you would begin by figuring out the NOI:
- Add up all revenue streams to get the property’s gross income. If you’re looking at a multifamily rental property, you would want to add up each tenant’s annual rent.
- Add up all of the property’s expenses: Figure out the annual cost of property taxes, insurance, utilities, repairs, maintenance, administrative and management fees and add these costs together.
- Factor in potential vacancies: While you should look at your market to see what local vacancy rates are, you can also assume a vacancy average of 10%. So, take your annual rental income and subtract it by 10% (or whatever the market vacancy rate is in your area).
- Take the result and subtract the rest of the property’s expenses, which will give you the property’s NOI.
Once you have the NOI:
- Calculate the cap rate: Divide the NOI by the property’s current market value: Remember, the current market value is the property’s purchase price.
Applying The Cap Rate Formula
Now, take a look at how this calculation would work if you were interested in buying a 10-unit apartment building. Let’s say the asking price of the building is $1.2 million, and current rents for each unit are $835 a month.
Step 1: Add up all income streams to get the property’s gross income.
You first want to find the monthly rent for the building, so you multiply $835 by 10 and get $8,350. Now that you have the monthly rental income of the building, you want to multiple it by 12 to get an annual rental income of $100,200.
Step 2: Add up all of the property’s expenses.
Next, you want to add up the building’s annual expenses. So, you would want to find the sum of the following costs:
Property Taxes: $14,000
Property Insurance: $2,500
Repairs and Maintenance: $7,000
General and Administrative: $2,000
Management Fees: $3,500
Total expenses: $33,000
Step 3: Factor in potential vacancies.
Although you would normally check your local market’s vacancy rate, we will assume a vacancy average of 10%. So, you would subtract 10% from the total gross income under the assumption that you can expect at least 90% of your units to be occupied in the first year of owning the property.
Now, 10% of $100,2000 is $10,020. When you subtract this amount from the gross income, you are left with $90,180. That means that your rental income should be $90,180 after accounting for potential vacancies.
Step 4: Take the result and subtract the rest of the property’s expenses.
Having adjusted the gross income by the vacancy rate, you now subtract the property’s total operating costs from the remaining rental income. $90,180 - $33,000 = $57,180. That leaves you with an NOI of $57,180.
Step 5: Calculate the cap rate.
Now, it’s time to plug in the NOI and purchase price to find the cap rate.
So, $57,180 / 1,200,000 = .0477. Therefore, the cap rate for the 10-unit apartment building is 4.77%.
Calculating A Stabilized Cap Rate
If you plan on doing work on the property shortly after purchasing it, you would have to adjust your calculations to get the stabilized cap rate, which reflects future improvements. Let’s say you wanted to increase your NOI by renovating the bathrooms and kitchens in all of the units. Those improvements would not only allow you to charge more for rent, increasing your revenue, but also add value to the property overall. Let’s take a look at how you would factor these improvements into your calculations.
If you knew that you could get $1,100 per month for each unit after renovating the bathrooms and kitchens, you would increase the property’s gross income revenue to $132,000. The property’s annual expenses would remain the same at $33,000, but you would have to recalculate the cost of vacancies: $132,000 – 10% = $118,800. Subtract the annual expenses from that number, and you get your NOI, $85,800
If you priced out your renovations and believed that you could get all the work done by spending $5,000 a unit, you would multiply $5,000 by the number of units. The cost of renovating the property would then be $50,000, so you would add that cost to the purchase price of the property. Now, the current market value of the property is the purchase price plus the renovation costs ($1,200,000 + $50,000 = $1,250,000).
To calculate the stabilized cap rate, you would divide the new NOI by the adjusted current market value of the property: $85,800 / $1,250,000 = .0686. So, your stabilized cap rate would be 6.9%. So, you can see that improving the property leads to higher returns, but it’s now a riskier investment. Even though you’ve done your homework and found that other renovated units are getting $1,100 a month, there’s still a possibility that you won’t be able to rent out those units for that price. So, you’re taking a higher risk.
When To Use And Avoid Cap Rates
Cap rates are a great tool for comparing the risk involved in different investment properties. If one property has a cap rate of 4.7% and another has a cap rate of 10%, you can deduce that the former property has a more stable cash flow stream. While the property with a 10% cap may make you more money in the short term, it generally carries a greater risk for losing some portion of that revenue stream.
But remember that cap rates are a simplistic method for valuing real estate. They are really only used by investors to determine if a property is a good deal that’s worth further consideration. For properties that have acceptable cap rates, investors will then use a full discounted cash flow analysis to evaluate the property’s value based on what its future revenue will be. So, while the cap rate assesses the value of the property over the first year of owning it, the DCF analysis provides deeper insight into the cash flow year over year. Therefore, DCF analyses are used to calculate the property’s actual return on investment.
Although house flippers can technically be considered real estate investors, cap rates are not a useful tool when buying a property, fixing it up and putting it back on the market at a higher price. Generally, speaking cap rates should not be used to value single-family homes, nor should they be used when the income stream of a property is irregular.
Multiple Approaches To Cap Rates
While the approach to calculating cap rates described above is often considered the simplest, there are other ways to calculate cap rates, like the Gordon Model and the Band of Investment model.
For those who find this process to be a bit convoluted, it may be helpful to consider cap rates in a different way. If you’re familiar with evaluating other types of assets, such as stocks or companies, it may be easier to understand cap rates as the inverse of a multiple.
Companies are valued as a multiple of their earnings. For example, Apple’s current P/E is approximately 23, which means that it is trading at a 23 times multiple of its earnings. So, for simplicity’s sake, let’s say Apple was making $1 million a year. At Apple’s current multiple, the company would be worth $23 million (23 x $1,000,000 = $23,000,000).
But if the asset, “Apple,” was an office building, you would say that it’s worth a 4.34% cap rate, so you would take the earnings – or NOI, as it’s referred to in real estate – of $1 million and divide it by 4.34%, which would give you the same valuation, $23 million.
Therefore, another way to determine the cap rate is to figure out the multiple, how much more a property is worth. For example, if a property is worth 20 times its income, then the cap rate is the income divided by the value, or 5%.
Final Thoughts On Cap Rates
Cap rates are a very useful tool for potential buyers who are interested in purchasing commercial or multi-family properties as an investment. Since cap rates provide a simple method for assessing the value of a property, they should be the first step to determining if a property will provide enough revenue to justify the risk of investing. However, you must keep in mind that there’s no threshold that makes a cap rate good or bad. You must judge cap rates based on your investment goals.
While a higher cap rate signals that the investment is riskier, it also shows that the property is likely to generate a higher revenue stream. So, when evaluating investment properties, you should always consider what kind of return you want on your investment. If you’re younger, you may be willing to take on more risk because you have more time to recover your investment. However, if you’re closer to the age of retirement, you’ll probably want to make a less risky investment even though it has a lower return.
In many ways, it’s best to speak to a real estate agent about your goals. Agents can also help you determine the cap rate for a particular property by looking at real estate comps.