For real estate investors, there are few metrics more popular than cap rates. Cap rates are a key metric that can give investors critical insight into the potential of their real estate investments.
Explore the meaning of cap rates with Christina in our real estate investing guide to understanding cap rates.
What Are Cap Rates?
A capitalization rate, or cap rate, is a measurement of a real estate asset’s ability to generate a return on an initial investment. In other words, it provides investors with a rate of return on their real estate assets.
Usually employed on many prospective properties, measuring the cap rates on multiple assets helps investors assess which property best suits their investment strategy. Real estate assets can vary drastically from street to street, from neighborhood to neighborhood.
It is essential to have the means to distinguish one property’s future potential from another’s. Therefore, understanding a property’s capitalization is a critical first step in determining its ability to generate a return and its value in a real estate portfolio.
Cap rates are a fundamental measurement for real estate investors; it’s one of the most popular tools investors use to assess an asset’s potential. Among the many measurements real estate investors use to assess properties, it is one of the more basic.
Cap rates essentially assume a property is paid for in cash and projects a return over a one-year timeline. While basic, cap rates nevertheless provide a quality starting point from which investors can explore the potential of their prospective assets.
How To Calculate Your Cap Rates
To calculate the cap rate of a real estate asset, one must first determine its net operating income or NOI.
What Is Net Operating Income?
The net operating income of an asset is the sum total of the asset’s income streams subtracted by the sum total of its expenses; in essence, NOI establishes an asset’s cash flow from its incoming income streams and outgoing expenses.
Real estate assets may generate income in a few ways, the most common of which is through rental income. In the case of a rental property, the total rent paid by the tenant constitutes the majority of the income streams of the asset. Other income streams must be added together in total before the asset’s NOI can be determined.
When the total income streams are established, one must then find the total expenses on the property. Real estate assets may have a number of outgoing expenses; the majority of expenses of a real estate asset are generally referred to as operating expenses.
Operating expenses include required maintenance, insurance payments, and property taxes. Additionally, calculating potential vacancies or the vacancy rate for a rental property accounts for expenses from lack of funds.
Once these two sums are established, investors can calculate the property’s NOI by subtracting the expenses from the income streams of the property. With the NOI, one can find the property’s cap rate by dividing NOI by the property’s current market value.
What Is the Current Market Value?
The current market value is the straightforward market value of the property. When calculating a property’s cap rate, the current market may be interchangeable with the purchase price amongst some investors.
More often than not, investors will use the property’s current market value in their calculations.
With the current market value established, the next step in calculating the property’s cap rate is to divide the NOI by the current market value. In essence, this determines the rate at which the net operating income will reach the current market value.
Suppose the NOI of a property was 5,000 dollars per month or 60,000 dollars a year. If the current market value of a property is 600,000 dollars, the formula used to find the cap would be 60,000 dollars divided by 600,000 dollars, resulting in.10. Multiply the result by 100 to convert to a percentage. The cap rate of the property is 10%.
Because the NOI is a measurement of annual income, the final cap rate gives a projection of how long it will take to reach that rate.
What Influences Cap Rates?
The formula for cap rate is fairly simple. But other factors can influence whether the projected cap rate is realized as calculated.
While cap rates can give investors a compelling picture of an asset’s future, the future is always subject to change. Accounting for real-world factors that can reasonably affect an asset’s ability to make a return gives investors a more high-resolution understanding of their cap rate.
Here are a few factors that affect realized cap rates to consider:
- Market competitiveness
- Market potential
Location is one of the most influential factors that determine a real estate asset’s value. Therefore, location has a profound impact on the realization of a projected cap rate.
Consider two carbon copies of the same exact property, one in the Westside region of Los Angeles and the other in a rural location; the Los Angeles property is essentially guaranteed to be more valuable. It’s generally understood that location will drastically affect the value of a property, even if they are virtually the same.
Assessing the quality of an asset’s location is key to understanding its ability to generate the kind of income to realize its cap rate. Choosing a good location is tantamount to choosing a better cap rate.
Determining the stability of an asset is crucial to understanding whether or not it will realize its cap rate. Fluctuations in the market can manifest in unpredictable ways.
Assessing a property’s ability to withstand relevant trends in the market gives investors a better idea of its stability. The more stable the income stream is for a given asset, the stronger a property’s chances are to make good on its projected cap rate.
The more stable an asset, the more confident investors can be about its projected cap rate.
The market of a given asset has a huge impact on its value. Larger, more competitive markets typically have lower cap rates.
The higher demand for competitive properties typically results in higher-value properties that produce higher levels of income. Highly competitive markets, like Westside Los Angeles, are more likely to follow through on their projected rates compared to smaller, less competitive ones.
Assessing the competitiveness of the surrounding market provides insights into the future performance of a given asset.
Identifying undervalued markets primed for growth is a surefire means to get a better return. While the cap rates of properties in undervalued markets may appear less favorable on paper, their increased potential for growth can affect an asset’s ability to provide a return. If a market is on the rise, the cap rate will be much stronger than it appears.
Finding markets primed for growth, no matter how niche, can be instrumental in affecting a favorable cap rate.
What Do Cap Rates Tell You?
Getting the cap rate for a property tells you how long investors can expect to get a return on their investment. A high or low cap rate can have different meanings in different contexts. Interpreting the favorability of a cap rate depends on a number of factors, but in general, the lower the cap rate, the more favorable the property.
High capitalization rates imply a certain level of risk associated with the property. Consider the formula for calculating cap rates: NOI divided by current market value. A higher percentage in cap rate implies that a property’s net operating income is significantly outperforming its market value. In all likelihood, high cap rates are unstable and unsustainable.
Alternatively, cap rates between the 5 to 10 percent range are generally understood to be “good” in most contexts. Low cap rates generally correspond to low risk. Investors can more confidently expect their assets to consistently capitalize on a return.
What Other Metrics Should Real Estate Investors Know?
While cap rates can provide investors with vital information about a property’s potential, they are far from telling the whole story. Investors interested in real estate assets should consider additional measurements of a property’s potential, like internal rate of return (IRR) or return on investment (ROI).
The more measurements investors have to assess a property’s potential, the more tools they have to build a stronger, more stable portfolio. Putting together the information gathered through financial metrics like these can be difficult. To ensure you’re getting the full picture of a property’s potential, consider investing with a professional investment firm.
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Christina has thrived in the country’s most competitive market—the Westside region of Los Angeles—because our firm has the knowledge, power, skill set, and vision to accurately assess the potential of L.A.’s hottest properties.
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