What You Need to Know about Cap Rates as a Sophisticated Investor
by Christopher Levarek
“There is geometry in the humming of the strings, there is music in the spacing of the spheres.”
- Pythagoras
I remember my first experience with cap rates. I was at a in-person local real estate monthly meetup in Phoenix in some nearby bar. My family and I had recently purchased some duplexes in North Carolina, one of our first, and someone asked me what the going cap rate was for that area. I had no idea what they were talking about as the color rushed to my face and not for the first time in my real estate journey, I asked “What’s that?”
Perhaps, this has happened to you or perhaps you’ve never heard of cap rates yet either. Not to worry! In this article, we will go into what exactly a cap rate is, how it’s calculated and why it’s important for a accredited or sophisticated investor. Let’s jump in!
…so What are Cap Rates?
The cap rate, also known as the capitalization rate, is simply a number that is used to express a basic return for real estate property. Investors will use the cap rate to validate the return on investment if they were to purchase an asset.
A 6 cap property would thus mean the property has a cap rate of 6% or should provide a 6% return on capital invested at current property expenses/revenues.
Calculating the Cap Rate
Let’s look at an example property and walkthrough how the cap rate is calculated. It’s really not too tough!
Cap Rate Example
If we have an example property valued at $2 million. Let’s assume it’s bringing in about $200,000 in rental income per year. It also subsequently generates $100,000 in expenses per year. With these numbers, we can calculate the cap rate.
Property value : $ 2,000,000
Rental Income (Revenue) : $200,000
Expenses : $100,000
Now we calculate the NOI, Net Operating Income.
Net Operating Income (Revenue - expenses) = $200,000 - $100,000 = $100,000
At this point, we simply divide the NOI by the Property value and that is your Cap Rate.
$100,000 (NOI) / $2,000,000 (Property value) = 5%
Cap Rate Formula is thus quite simply : NOI / Property Value = Cap Rate
…and that’s it! This really just means that for this example property, we can expect to bring home $100,000 in profit or return on investment. At it’s base level then, a cap rate that is higher demonstrates more return.
So if someone was comparing a 5 cap property versus a 10 cap property, the investor would choose the 10 cap as this is a 10% return on invested capital roughly. A bigger return means a faster repayment of capital invested and typically the better investment choice.
How are Cap Rates Used?
In general, cap rates are used by investors to validate a good purchase or forecast a sales price. So an investor would look at 3 properties for example and use the cap rate to compare which one might make the better purchase. Additionally, an investor would look at what they believe the cap rate would be in say 5 years if they were to sell the property to help performance projections(more to come on this later).
Cap rates are thus used to be a general measurement of an asset class or market by potential buyers or sellers.
What should you know about Cap Rates, As an Accredited or Sophisticated investor?
The cap rate is not the end all be all for an investor. In fact, it should be one of the data points considered for a good passive investment but definitely not the most important. There are two basic points to consider if you are vetting an investment as a passive investor regarding cap rates :
1 - Is the Investment Property cap rate Similar to others in the Market?
Cap rates for similar assets will be very near to one another. So three apartments in Phoenix, AZ should be trading at similar cap rates for comparable type properties. In other words, if you verify the Phoenix, AZ cap rate average is around 4% for other similar assets but your investment opportunity deal is presented as a 9% cap rate, you might want to do some more due diligence. If it appears too good to be true, it just might be.
2 - What is the Exit Cap Rate?
I mentioned this above in brief, but the exit cap rate is the cap rate at sale. This is also known as the “reversion cap rate”. It’s used to project out what an investor thinks the property will be sold at as well as the NOI(net operating income) at said period.
This one is a very key number to look at for any passive real estate investor. When presented with a potential investment opportunity, you should always ensure the exit cap rate is higher then the purchase cap rate. So if the purchase cap rate is 6%, then the exit cap rate should be 6.5%.
Having a higher exit cap rate then the entry cap rate is quite simply conservative underwriting and means the syndication team is projecting the market will be worse at sale. This is a good for the investor and means the team is ensuring the deal makes sense even if the market is worse. If it makes sense when the market is worse, the investor’s capital is further insulated or protected.
What you do not want to see is a exit cap rate that is below the entry cap rate. This will make the return for investors look really good but it also is somewhat risky to assume on paper the property will definitely sell at the best price or cap rate possible.
In Final
Cap rates are simply a calculation at a specific time based on current or projected performance of a property. However, they are not the only way to value a property and they should not be the only method to judge a good investment.
As a passive real estate investor, understanding the real estate investing terminology can ensure you are not left in the dark when reviewing potential opportunities. Just as important however, when selecting an investment opportunity, should be the relationship with the management team and their track record.
If the team has performed well in the past and you know, like and trust them, that is usually the best indicator for success. Happy Investing!