Welcome to a segment of Real Estate Investment!
In this blog, we will dive into the concept of the Capitalization Rate. But before getting ahead of ourselves, it would be essential to backtrack a bit and review my Blog, Understanding Net Operating Income (NOI). We will need to calculate NOI before finding the Capitalization Rate.
Capitalization Rate is a fundamental concept in commercial real estate. It is a tool, among others, to help Real Estate Representative and investors evaluate commercial and residential commercial properties. It is also a valuable tool in determining a potential rate of return. It is typically used before purchasing a commercial property, but can also be used once you own the property and even before you put the property on the market to sell it
You can come back as often as you want and use the FREE Capitalization Calculator.
As I said in my Blog, Understanding Net Operating Income, BEWARE of those Real Estate Representative who can exhale commercial real estate words. They sound knowledgeable and seem to have a good understanding of commercial real estate, but the fact is, most DO NOT. I have heard many of them verbalize or write things in the listing like “a good cap rate; excellent profits; positive NOI” or something to those effects. However, when questioning them on the matter, it becomes evident that they have a minimal understanding of what they are saying. PLEASE BEWARE!
WHAT IS CAPITALIZATION RATE (CAP RATE)
The capitalization rate, known as Cap Rate, is a common and useful ratio in the commercial real estate industry that helps evaluate a real estate investment. It gives a first-hand indicator of the worthiness of a commercial entity. However, it is not an exhaustive measuring tool!
Cap Rate is a ratio that shows the potential rate of return that is expected to generate a commercial property. It is used to estimate the investor’s potential yield on their investment in the real estate market and helps determine if the venture is a good deal should they purchase the property.
The Cap Rate is calculated based on annual returns of a real estate commercial property. It is a simple formula that provides just a number that measures an abstract concept of risk. But it is a convenient analytical tool! It helps investors make informed overall decisions about their real estate and financial objectives.
Capitalization Rate =
Net Operating Income / Current Property Market Value X 100
The first step is to calculate the Net Operating Income (NOI) of the property. You can use my FREE NOI cost calculator by clicking on the following link FREE Net Operating Income (NOI) Calculator that will open in a separate window. Once you have determined the NOI, you can use my FREE Cap Rate Calculator below. The calculator will give an output of your Capitalization Rate.
The Cap Rate equation can also be used to determine property value.
Property Value = NOI divided by Cap Rate
Although it is beyond the scope of this blog, Capitalization Rate can also be used to calculate other concepts in real estate investment such as the cost of debt and the cost of equity capital for the purchase of an income-producing property.
A Real Estate Representative shows two income properties.
This is an 8-unit residential property. It is available at a firm price of $500 000. Not fully rented and has consistent vacancy losses. The building will require a new roof and exterior cladding in a few years but is located in an excellent area. The hospital, schools and shopping amenities are in the same town as the residential property. The NOI trend tends to fluctuate because of vacancy losses. This year is a better year than the previous year.
The Net Operating Income is $42 000
Cap Rate is 8.4% (42 000 / 500 000 X 100 = 8.4)
This is a 5-unit residential property. It is available at a firm price of $500 000. It is fully rented with long term tenants with minimal tenant turnover. The building needs no major repairs and is situated in a good location. The nearest schools, hospital and shopping amenities are located in another town about 15 kilometres away. The NOI trend over the years has been stable.
The Net Operating Income is 32 400.
Cap Rate is 6.48% ( 32 400 / 500 000 X 100 = 6.48)
Which property would you buy? Which property is a good “Cap Rate”? It will depend on your comfort zone regarding your level of investment risk
You like Property #2 because it produces stable income, has a stable and steady NOI trend over the years and has good long-term tenants. Buy it, relax and start collecting revenue.
However, Property #1 NOI is higher and has a more profitable potential with a Cap Rate 2% higher than Property #2. But it has more moving parts or risks: NOI tends to fluctuate year over year, consistent vacancy losses and requires some significant repairs.
With investment decisions, there are no clear-cut answers. It all depends on your investment criteria, strategy, preference and your “risk investment” comfort zone. Property #2 would be more suitable for investors seeking a more stable passive investment experience. Property #1 would be a good fit for entrepreneurial investors. The potential returns are more significant if everything goes well. The investor can digest the nail-biting experience and uncertainties as the higher return outweighs the investment risk.
Well, I certainly fall into the more stable and passive investor category.
As a realtor, we can also provide a projection of what I call the “what if Cap Rate” to a Seller and Buyer clients.
Let’s say a residential income rental property is listed at $299 999. The property is located in a small populated northern Ontario town, where the commercial real estate market is sluggish and is known to be a buyers market with few buyers looking for investment properties.
Let’s say the NOI is $15 555. This is were the projected “what if Cap Rate” comes into play during the negotiation process.
What if the purchase price was 299 999. Cap Rate is 5.18%
What if the purchase price was 265 000. Cap Rate is 5.86%
What if the purchase price was 250 000. Cap Rate is 6.22%
What if the purchase price was 200 000. Cap Rate is 7.77%
Although this may seem an unrealistic approach for investors in the large populated metropolitan areas with dynamic real estate investment market, nevertheless it is a common reality in a lower-demand area like many northern Ontario cities.
INTERPRETATION / WHAT IS A GOOD CAP RATE
With investment decisions, there are no short clear-cut universal answers. It all depends on your investment criteria, strategy, preferences and your comfort zone with “investment risks.” Understanding and having a solid grasp of these preferences will pave the way for investor defining a good Cap Rate. Cap Rate can be subjective and various real estate investors with different investing strategies look at it differently.
The rate also impacts the duration of time it will take to recover the invested amount in a property. For instance, a property having a Cap Rate of 10% will take around ten years for recovering the investment. A property having a Cap Rate of 5% will take approximately twenty years for recovering the investment.
Keep in mind that you should compare apples to apples when deciding if a property has a reasonable Cap Rate. It is influenced by demand, the availability of inventory and the specific type of property. A multifamily investment property Cap Rate will generally have a much lower cap rate than a commercial building with retail tenants but so are the risks involved.
The desired sought after Cap Rate with differ from a Buyer and Seller investors perspectives.
Buyers want a high Cap Rate. This means the value of the property is low, your initial investment is lower, and the purchase price of the property is low in comparison to the NOI.
Sellers want a low Cap Rate. This means the value of the property is high and the sale price of the property is high in comparison to the NOI.
Remember, as a Buyer investor, the higher the Cap Rate, the larger the return on your investment.
Generally speaking, the rule of thumb is,
A good Cap Rate is between 4 and 10% or higher, depending on high or low demand areas.
An investor needs to weigh many factors, the risks level and their investment goals. Therefore it is prudent and wise to measure up the Cap Rate against other investments like bonds, locked in investment rates, mutual funds etc.
The Capitalization Rate is focused on the property and is not distracted by debt such as the financing used to purchase the property. The Cap Rate assumes the property is purchased for cash without the leverage of a down payment and financing.
Mortgage payments, loans, or other costs associated with purchasing an investment property like lender fees, real estate fees, legal and closing costs are excluded from the Capitalization Rate formula.
WHEN TO USE THE CAP RATE
When purchasing or evaluating,
Multifamily residential property
WHEN NOT TO USE THE CAP RATE
The fix and flip
We’ve dived into Cap Rate. This ratio is important, but it should not be used as a sole indicator of an investment’s strength. It does not take into account financial leverage to acquire an investment property. It is only one of many investment criteria and formulas you can use to analyze and evaluate an investment property.
Keep in mind there are no single explicit ranges for a good Cap Rate. Real Estate Representatives need to take a holistic approach in understanding their client’s investment criteria, strategy, preference and comfort zone with investment risks.
OTHER HELPFUL ARTICLES / LINKS
ABOUT THE AUTHOR
The above Real Estate information topic of discussion was provided by Marc Martin, Your Real Estate Guru! Marc created marcrealestateguru.blog site because of a need to provide a trustworthy, authoritative and a leading blogging home to “Keeping Real Estate…Real.” Its various insightful blogs will benefit Sellers, Buyers, Realtors and anyone interested in Real Estate. Genuineness, truthfulness and straightforwardness are the building footings for every article. Marc can be reached by email at firstname.lastname@example.org or by phone/text at (705) 676-7799.
Marc has helped people move in and out of many homes in the Temiskaming Shores area and strives for perfection in every transaction. “I do more because you are worth more, and being a protector of my client’s interest is the single most crucial factor in my business!”
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