What is Cap Rate?
How do I use it to select a winning real estate investment?
When it comes to real estate investment the terminology can seem confusing but when you break them down individually, the calculations are not that complex. The key to the calculations though is interpreting them relative to the market you are in. In this article we look at what is capitalization rate (cap rate) and how it help real estate investors analyze both potential investments as well as properties in their portfolios.
What is Cap Rate?
Simply put, the cap rate is the ratio of a rental property’s net operating income (NOI) to its current market value over a one year period.
For a cap rate calculation, mortgage payments, lender fees, depreciation, income tax and closing costs are not included. This may seem inaccurate as we know leverage is a key benefit of real estate investment but it is actually an excellent measure of how the property will potentially perform. This calculation converts your annual income stream (NOI) into a capital value. It is the main valuation approach used by banks & CMHC for multifamily properties because it is not subjective, it uses the current income of the property and not the projected income. However, as leverage is not included in the calculation it one of many calculations in a real estate investors toolbox.
Cap Rate = Net Operating Income (NOI) ÷ Current Market Value of Asset
Net Operating Income = Total Rental Income – Expenses
Note: Your goal is always to maximize NOI. If you increase your NOI, you are increasing the value of your property.
Current Market Value of the Asset = current market value + the value of any initial repairs or renovations required.
The capitalization rate is used to determine the return on your investment dollars for a one year period. Generally speaking a low capitalization rate implies lower risk but higher price and a high rate implies higher risk with lower price. A cap rate is typically used prior to purchasing a property but can also be used when you are putting the property on the market to sell.
We can see here that we have a property with a cap rate of 8.14 % but what does this mean when analyzing a property?
A cap rate between 4 – 10 percent is usually considered good but there are factors to evaluate:
Available inventory in the area
Type of property
Location – large cities with high demand may have an average cap rate of 4% where smaller centers may have a higher, so understanding the cap rate relative to your location is key.
To check your cap rate assumptions for your selected location, check with your mortgage broker or a trusted real estate agent.
For these reasons it is important that when you are evaluating your investment properties that you are comparing properties in a similar location and within the same asset class. You should always include the allowance for vacancy based on current market analysis within your calculation, this gives you a more accurate calculation specific to the location.
When to Use Cap Rate
Cap rate is a good calculation for long-term investment prior to purchasing a property or before putting a property on the market. When you are looking at a buy and hold investment in single-family houses, condos, townhouses, multifamily properties, apartment buildings or commercial real estate investments cap rate is one of the tools you should use to evaluate your property. However, when investing outside multifamily, commercial and industrial properties, values will primarily be based on comparable sales by lenders.
You can use a Cap Rate calculation to determine what your return should be on an investment. For example, if you purchased a property for $1.5M and the current average cap rate is 5%, you would expect an annual income of $75,000.
As well, Cap Rate can be used to determine your current investment performance relative to others in your market. If your cap rate is lower than the average it is possible your rental rates are too high, you should pay close attention is you have renters leave your property. Inversely, if your cap rate is higher than average it could indicate that your rents are lower than average for the area, your expenses are higher than they should be or your property may need to be updated to maximize your investment value.
When Not to Use Cap Rate
There are real estate investments that you should not use a cap rate calculation to analyze your deal. As mentioned, cap rate is generally used for buying long-term investments and therefore when purchasing a flip property it would not be a useful tool. Other types of investments that would not benefit from a cap rate calculation include: land (land is vacant and therefore does not have income), vacant properties (there is no income if vacant), short-term rental (cap rate is calculated on an annual basis) and properties that will not be rented for a full year such as a vacation rental that will not be occupied year round.
Examples of Other Calculations for Property Evaluation
Cash Flow: calculates how much cash remains from monthly rental less expenses. As a long-term investor you are looking for positive cash flow properties.
Cash on Cash ROI: Measures the return on your capital. Annual pre-tax cash flow / total cash invested.
Gross Rent Multiplier: Purchase Price or Market Value / Total Annual Income
Breakeven Ratio: Gross Rental Income to total operating expenses (including loan payments). A high break-even ratio is a red flag to both lenders and investors.
Debt Service Coverage Ratio: measures the operating income available to debt servicing including interest and loan principle payments. Net Operating Income / Debt Service.
Cap rate is a key tool to evaluate potential investments but it is a key understanding the value of the property and determining if the asking price is in line with the market. To summarize:
Cap rate measures the profitability and risk level of an investment property.
Cap rate = Net Operating Income (NOI) / Current Market Value
There are numerous other tools that should be used to fully analyze an investment property, cap rate should not be the only metric.