What Is A Cap Rate
As a real estate investor, one of the most important aspects of your success is found in the ability to project the profitability of an investment property. Before you commit any of your money or time to a property, you need to determine whether or not that property will yield enough of a return for your investment goals. One of those tools that can be used to perform both of those tasks is known as the cap rate (also referred to as the capitalization rate). For years, real estate investors have relied on the cap rate in order to determine the viability of an investment property. Let’s break down what the cap rate is, how to determine it and how it can be a useful tool for you.
What is Cap Rate?
Cap rate is the most popular metric among real estate investors who want to determine the viability of a potential investment property. Cap rates simply projects the profitability of a property over the course of a year. It is important to note that the cap rate formula assumes that an investor paid cash for a property instead of obtaining a mortgage for it. The capitalization rate of a property is used to indicate the property’s un-leveraged, intrinsic and natural value.
What is the Cap Rate Formula?
There are multiple formulas available that you can use to determine that cap rate on a property. However, the most frequently used formula simply relies on dividing the property’s net operating income, also referred to as the NOI by the property’s current market value.
The net operating income is easy to calculate, as it’s simply the amount of income generated by a property over the course of a year minus. For instance, let’s say that you are considering a 10-unit apartment building for investment. The monthly rent for each unit is $1,000. Therefore, the property generates $10,000 per month which translates to $120,000 per year. In order to determine the NOI of the property, you will need to subtract the cost of property taxes and the annual cost of maintenance, other expenses and repairs. In our hypothetical situation, we will assume that the property taxes are $2,500 per year. Additionally, you will need to spend $25,000 per year on other expenses and maintenance costs associated with the property. Those numbers leave your NOI at $92,500.
Let’s assume that the apartment complex’s market value is $250,000. Simply divide $92,500 by $250,000 to determine the cap rate. In our hypothetical, the cap rate is 37.5%, which would be an incredible cap rate on a property. You’re unlikely to ever find a cap rate that high, but again, this is just a hypothetical.
What to Remember With Cap Rate
The most important thing to remember when utilizing cap rate to determine the viability of a potential investment is that it’s a projection. While you may be able to look at the property’s current annual income generated in order to complete the projection, it’s important to remember that there’s no guarantee that a property will maintain its value in the future, as external factors play a pivotal role in any property’s value. Keep in mind that with a value add strategy, you may be able to manipulate the value of the property down the road by adding additional value to the property through renovation, increasing rents and other management focused strategies.
Many people wonder, “What is a good cap rate?” There’s no clear answer to that question, as every investor has a different strategy and unique goals for their investing. For instance, if you intend on holding onto an investment property for the long-term, you can accept a lower cap rate, as you’re prepared to recoup your money and turn a profit over a number of years. The key to using cap rates to evaluate a property is simply to find a property that provides the returns that match your personal investing goals.