On the surface, real estate seems like it would be a simple investment. Property values typically go up over time, so just buy a house and wait. Of course, there’s a lot more to it than that, though, and determining which available properties would be the best investments for you is often a difficult and complicated process.
Each individual buyer has their own factors that affect the viability of a particular investment, such as their tax bracket, or property debts, making real estate investments somewhat subjective. So how do you determine, objectively, if a particular property is worth investing in? You look at the capitalization rate, or cap rate. Here’s what you need to know about them.
What Are Cap Rates?
The cap rate is the expected rate of return generated by a real estate property—i.e., how much income you can expect to generate from it over the course of one year. It lays aside all the individual factors that make it subjective and just calculates potential income based on property value. The cap rate assumes that the property is being purchased all at once, in cash, rather than mortgaged, so factors such as debts and interest rates don’t enter the equation.
Appraisers and real estate brokers use cap rates to establish a property’s fair market value. Investors can also use them to get a ballpark figure of how long it will take to recover the money they invest in the property.
Calculating Cap Rates
The formula for calculating a property’s cap rate is simple. Divide the net operating income (NOI) by the property’s total value. NOI is how much you expect to generate from the property in a given year, before taxes, financing, and other costs.
The main type of NOI is rental income. How many tenants can the property support and how much will each of them pay in rent per month? Add them all together and multiply by 12 months, and you’ve got an idea of your annual earning potential.
However, net income doesn’t stop there. Are there paid laundry facilities on the property? The quarters people put into those are part of your NOI. If paid parking facilities exist, those contribute also, as well as any other amenities offered on the property to tenants, guests, or anyone else. That even includes vending machines. As long as you own them, the revenue they generate is part of your NOI.
Add up all of your net operating income and divide it by the amount you would pay for the property right now, in cash, free and clear. Say your NOI is $150,000. The property costs $2 million. Divide 150,000 by 2,000,000, and you’re left with a cap rate of 0.075, or 7.5%.
Interest rates play a role as well. They’re not factored into the cap rate equation, but they put cap rates into perspective. The cap rate formula assumes you pay cash, but that’s not what most people do. They get a mortgage that has to be repaid, which cuts into their actual profits. Therefore, as interest rates continue to climb, higher cap rates are necessary to yield the income you need.
Cap Rate and Property Value
We should also note that the equation works both ways. If you divide the net operating income by the cap rate, you get the property value. Which means, if your cap rate goes up, your property value goes down, and if NOI goes down, property value goes down as well. $150,000 divided by 7.5% is $2 million. But if the cap rate were to go up to 8%, $150,000 divided by 0.08 is just under $1.9 million.
Likewise if your cap rate goes down, your property value goes up, or your net income decreases. If your income becomes too low to be viable, it might be more profitable to sell the property than to keep it.
What’s a Good Cap Rate?
Once you’ve calculated the cap rate, how do you know if it’s worthwhile or not? It depends on what you’re looking for. First, the cap rate will tell you how long it will take to recover your money. With our 7.5% example above, it would take a little over 13 years to make back the $2 million purchase price. For some people, that’s plenty. Others refuse to invest unless there’s a cap rate of 10% or more.
Higher cap rates mean more potential income, but they also mean higher risk. The cap rate is the potential income, but the higher it is, the more difficult it becomes to maintain that level of income. For instance, if the cap rate is high because rent is also high, you might lose tenants and have a high number of vacancies.
If you have a building with 10 units that each charge $3,000 per month in rent, that’s an operating income of $360,000 per year. But if five of those units sit empty because tenants can’t afford them, it will cut your actual income in half. By lowering rent, you’d lower the cap rate, but you’d also have a better chance of filling those five empty units, yielding more money, rather than less.
As a general rule of thumb, if you’re looking for a fairly stable, long-term investment, a property with a cap rate between 5% and 10% is considered a good investment. If you’re willing to put in a bit more risk for the potential of a higher yield, look for a cap rate above 10%. However, existing interest rates can change what’s considered a good investment. Regardless, a 10% cap rate may make it difficult to maintain the level of income, but it may present an attractive price for the buyer. Whereas a 5% caprate may make maintaining the income level less risky while the purchase price could be steep. In general, increasing caprates are better for buyers while decreasing caprates are better for sellers.
In the end, the cap rate is just a rule of thumb. It ignores a variety of factors, which can have a significant impact on your potential income from a property. The cap rate is just a base jumping off point that puts every investor on equal footing.
But the important question is this: Is now a good time to invest in real estate? With rising interest rates, you might think the answer is no—but that’s not necessarily true. A variety of factors affect the real estate market and can help you generate a stable income. At Eiger Wealth Management, we can help you navigate those factors and find the best investment for your needs.
Contact us to learn more!
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