One of the most universally utilized formulas that investors use to make a quick assessment of a property's current investment return is the capitalization rate. It is commonly referred to as the cap rate, and it is a very simple calculation that provides a “snap-shot” of the return that a certain investment has made against the total cost of the project, usually over the last 12 month period.
It should be noted that the cap rate is expressed as a percentage, because the amount of investment capital re-captured over the last 12 month period is usually a smaller percentage of the total investment value. For instance, if one invested a million dollars into a project, and at the end of a twelve month period, the project realized a net profit $100,000, that investment would have a cap rate of 10%.
The cap rate is determined by dividing the net income by the price, as illustrated in the first example below. Conversely, one could also divide the net income by the cap rate, and determine the price:
What is the Net Income?
This is the total income that the property earns after reducing for vacancy and operating costs, such as property management, maintenance, property taxes, and insurance. From the example above, if the 1 million dollar property’s gross income was $100,000, but $50,000 of that income was spent towards operating costs, this amount would be subtracted, and the net operating income would be $50,000. This number would be carried into the net income portion of the equation, which we'll calculate below.
Price (or value) is a very important part of the cap rate because there are so many factors that can influence it. The price may be the original purchase cost, or the purchase cost plus any capital improvements required. If a property has been poorly managed, and much of the maintenance has been deferred, the purchase cost may be lower, but there may be additional expenses after acquisition in order to realize the property's potential. This is what investors refer to as a "value-add" opportunity.
The location may also have a bearing on the cost. If a property is located in a high-demand location with excellent potential for appreciation, the cost may be higher, since the risk is lower.
Cap Rate Calculation Examples
Cap rates can be difficult to calculate at first, so we’ve provided a couple of examples. Take the pricing example used in the Net Income section. The property’s rent was $100,000, but $50,000 of that income was spent towards operating costs for the property, and the net income is now $50,000. Now add the acquisition price of $1,000,000 to the equation, and it should look like this:
$50,000 / $1,000,000 = .05 (5% Cap Rate)
This would be the capitalization rate used to determine the annual return of the total investment.
Alternatively, if an investor required a cap rate of 7%, and it was known that the net income of the property was $50,000, that investor would apply the following formula to arrive at a price:
$50,000 / .07 (7% cap rate) = $714,285.71
The resulting number would then be the offering price for the property.
Remember that the cap rate is a simplistic formula, which is only designed to take a "snap-shot" of a property at a given point in time. It does not account for costs unrelated to the actual property, such as income taxes, and debt service.
Regarding debt service; it is important to remember that the income of the property itself has nothing to do with the method of acquisition. Therefore, the cap rate formula cannot consider loan costs. So, if that investment realized a net profit of 10%, but 5% of that profit had to pay the principal and interest for borrowed money, one would still have a 10% cap rate, even though the actual profit against the acquisition costs after debt service would be only 5%.
While a 5% return might not seem like much, if an investor has borrowed the majority of the money to acquire the property, his or her return on their own investment dollars is likely to be much greater. This is referred to as the Cash on Cash return, and is something we'll cover in another article.
Which is Better - Low or High Cap Rate?
Cap rate and price are inversely related. A lower cap rate means that the price is higher, and visa-versa. Usually, a lower cap rate would suggest a higher demand property, with lower risk, while a high cap rate means that there are other factors that may be reducing the property's value.
If you’re the seller, you’ll obviously want a low cap rate, and a high price. Alternatively, if you’re purchasing a property, you’ll want the cap rate to be high, because the price is lower. Keep in mind that a higher cap rate usually means that there is more risk associated with the property, but there is also the potential for higher returns.
What is a Good Cap Rate?
Most investors would consider 10% an excellent cap rate, but it has been a while since we've seen these kind of rates for stable investments with any regularity, especially for multifamily properties. Lately, acquisition cap rates on the Space Coast have averaged from 6-8%, depending upon the quality of the property, and the potential for growth. However, this is still comparatively strong considering we've been regularly seeing acquisition cap rates as low as 3% in places like California and Washington State.
Alternatively, if you're willing to invest in higher risk, or more rural areas, there are still some properties that are still being offered at better than 10%, but you will want to do your homework before buying based on the cap rate alone.
There are many factors that can influence a property's price, and many reasons for a seller to dispose of a property. It is imperative to fully analyze all the risks and potential benefits of an acquisition before committing for the long term. Be sure to utilize the expertise of an experienced advisor, as we can help you navigate any potential pitfalls before they happen.
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