As an investor, you do not go on buying commercial properties without considering their return on investment. After all, your main objective when buying a property is to earn profits. The Cap Rate is a quick metric to see if the property will be a profitable one or not.
One metric that is widely used by investors to know how well a property will do for them is Capitalization Rate.
Often referred to as simply Cap Rate, this is a tool that investors use to evaluate a commercial property before deciding whether to buy it or not.
Whether you are tempted by the location, condition, or the price of a property, it is not prudent to take a decision of buying until you have calculated its cap rate and found it to be a good property for investing.
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What is cap rate and how do you calculate it?
Cap rate is defined as the ratio of Net Operating Income and property asset value.
As an investor, you feel good when the cap rate is high as it can generate net profit for you after covering all operational expenses.
As a newbie investor, you will frequently come across this phrase. Owners, brokers, and fellow investors will be seen talking about cap rate and whether it is good or not.
For example, if you buy a property worth $500,000 and its NOI is $50,000, the capitalization rate would be 50,000/500,000 that is 10%.
How do you calculate cap rate?
Calculating cap rate is easy as requires knowing the net operational income form a commercial property.
Cap Rate = Net Operating Income (NOI) ÷ Purchase Price
However, herein lies the catch as you cannot arrive at accurate NOI until you have all the information about the past performance of the property.
You must find out everything from expenses on property taxes and insurance to all the expenses incurred on upkeep and repairs.
You have to add up all operational expenses and subtract them from the gross income received in the form of rent from the tenants.
This NOI is then divided by the value of the property and the result is multiplied by 100 to arrive at the Capitalization Rate.
If the Cap Rate of a property is 10%, it means that the investor can expect to obtain profits equal to the 10% of the value of the property provided this NOI and the value remains constant over a period of time.
What Factors Go into Cap Rate?
Net operational income (NOI) is the figure that an investor needs to find out to be able to calculate the cap rate of a commercial property.
This figure can only be an intelligent guess if you do not have access to all the metrics associated with the commercial property you are interested in buying.
Therefore, you should not be confused with the gross rental income of the property.
More important factor in calculation of cap rate is net operational expenses that decide how much of the income from the property can be referred to as net income.
Do you want a high or low cap rate?
Once you know that cap rate is the ratio of NOU and the price you pay for it, it is natural for you to look for properties having a high cap rate.
For some commercial properties, a capitalization rate of just 5% is considered good whereas for others, a minimum of 8-10% is a must before taking a decision of buying such properties.
As an investor you want the capitalization rate of the property to be as high as possible but as a landlord, you always want the cap rate to be low as you want to realize a high selling price for the same property.
What is a good capitalization rate?
Capitalization rate varies from one property to another as it is dependent upon monthly rents; demand among renters, maintenance costs, and of course property prices.
Knowing the cap rate of a property is essential to evaluate the potential return on investment.
In some places, a capitalization rate of 4% is considered good whereas in other investors look at a cap rate of 10% or higher.
In general, cap rate between 4-10% is considered as good by investors.
What is a good cap rate for apartments and multi-family properties?
Like every other commercial property, cap rate for apartment buildings varies from one area to another.
Of course, you are looking for a multifamily apartment building that can cover your operational expenses.
In general, good capitalization rate for apartments varies between 4 and 10%. If the building is in a location with high demand from renters, even a 4% cap rate may be considered good.
But if the property is in a neighborhood with poor demand from renters, an investor may require the cap rate to be close to or even higher than 10%.
How to use capitalization rate for real estate investing?
You never know how a property turns out after purchase. Therefore, it is very important to know how profitable a commercial property can be before taking a decision about buying it.
You may think that a property is very costly, but you feel tempted to buy the same property when you find that its net operating income is high, thereby giving a decent capitalization rate.
Also, an investor should not be fooled by gross income generated by a property because in some properties operational expenses are too high. It is advisable to arrive at net operational income after deducting all operational expenses form the gross income.
Now divide this amount with the value of the property and multiply the ratio with hundred to arrive at the cap rate of the property.
Capitalization rate can be used not only to determine the return on investment form a single property but also to compare two or more properties.
For example, if you see two commercial properties that are priced differently, you are often tempted to buy the property that is priced lower.
However, if its net operational income is low, you may be disappointed with the cap rate of the property.
This means an investor should not decide about buying a property only based on its price but compare the cap rate of available options to decide which one is right for his investment goals.
Cap Rate Trend Over Time
Another way to use cap rate when buying a property in a market is to look at the cap rate trend over a period of time.
If this rate is compressing, it shows that the real estate market in the area is heating up and prices are increasing at a brisk pace.
Looking at the historical trends of capitalization rates in a housing market, you can assume where these cap rates are heading in the next few years.
If you have $500000 in your bank account, you can invest in treasury bonds to get 3% return on your investment annually. You can do nothing and collect checks from the government for your investment.
But if you invest the same money in a commercial office building where the cap rate is 6-7%, you can earn more than double the amount of money easily by making some efforts.
This additional 3-4% return on investment is referred to as risk premium which means you must do all the work to earn this additional amount of money on your investment.
Treasury bonds are virtually risk free but to earn more profits, you must consider several risk factors that are mentioned below.
- Age of the property
- Trustworthiness of tenants
- Duration of lease agreements with tenants
- Vacancy rates in the building
- Demand among renters
- Prospects of the neighborhood in terms of economy and infrastructure development
When you examine all these factors closely, you know whether it is prudent worth buying the property to go for that 4% risk premium or not.
There is no math formula to allow you to come at a straightforward conclusion after the analysis of all these factors.
It depends upon your business acumen and the knowledge of the housing market to help you arrive at a decision about buying the property or not.
How Property Type Affects Cap Rate?
Capitalization rate of a property is affected mostly by its age, location, condition, and demand among renters.
However, it is also affected by property type such as residential, office, industrial, recreational etc. You deal with different types of tenants depending upon the nature of commercial property you buy.
Therefore, the factor that becomes most important for the investor is the nature of tenants and their lease terms depending upon the kind of property he is buying.
What is a good cap rate for rental properties?
It is important for you as an investor to look at the cap rate of the property when buying it.
In general, a capitalization rate that varies between 4-12% is considered good from the point of view of investment for an investor.
However, the investor also need sot look at the demand among renters, the number of such properties in the area, and the condition of the property before buying it solely based on cap rate.
What is the formula for calculating the capitalization rate?
The formula to calculate capitalization rate of a commercial property is simple and you only need to find out the net operational income from the property to calculate this rate. Just divide this figure with the price of the property to arrive at the cap rate.
This capitalization rate gives you an idea of the kind of returns you can expect on your investment and whether buying this property is going to be profitable for you or not.
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