What Is A Good Cap Rate For Rental Property?
If you’ve invested in residential real estate before then you have some basic lingo under your belt such as:
- mortgage interest rates
- purchase price
It’s okay if you don’t know what a cap rate is or how to calculate a cap rate formula as it can be challenging to understand and difficult to calculate.
As a passive investor, you won’t have to do any of the tough work to calculate cap rates, but it’s helpful to have a very basic grasp on what they are.
Similar to when I went to dental school. I had to learn information that I knew I’d never use (i.e. neuroanatomy!) but needed to be familiar with in case a professor asked a question about it on an exam.
Keep reading to find out:
- what a cap rate is
- how it’s calculated
- what it’s used for
- what you need to know about cap rates as a passive investor in a real estate syndication.
What Are Cap Rates?
Cap rate is short for capitalization rate and is used to indicate the rate of return expected for a particular property.
Investors use cap rate to compare properties and estimate their potential ROI (return on investment) for a particular asset.
When someone says a property has a cap rate of 5%, or that assets in a given area are trading around a 5-cap, they are talking about the potential investment property return.
How Are Cap Rates Calculated?
There are multiple ways to come up with a cap rate, so be sure to always ask how it was calculated when performing your due diligence.
Most cap rates are calculated by taking the net operating income and dividing it by the market value.
Cap Rate Example
Let’s take a look at a commercial property (office building) valued at $1 million. Over the past year, it’s brought in $100,000 in rental income.
After paying $50,000 in operating expenses, we end up with $50,000 in Net Operating Income NOI or cash flow.
We take the NOI of $50,000 and divide that by the total value of the property.
$50,0000 / $1,000,000 = 5%
This means if we bought that property with $1 million dollars today, we could expect to earn $50,000 in net income over the course of one year. This is your Return on Investment or ROI.
One way to think about it is that it’d take 20 years of long term returns at $50,000 to recoup your $1 million initial investment. This does NOT take into account appreciation which more than likely the property would go up in value on average.
If the property generated $150,000 with the same $50,000 in expenses, the cap rate would be $100,000 divided by $1 million, which would equal 10%. In that case, it would only take 10 years to recoup your initial investment value.
The higher the cap rate, the faster you’d earn back your investment capital, and the better the investment choice.
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How Are Cap Rates Used?
Some investors rely heavily on cap rates and look for investments with cap rates of 8% or higher. However, that’s just one data point (from only one particular year) on an asset.
Cap rates don’t take into consideration other factors like loans or time value of money.
When comparing different properties in the same market, cap rates can be very useful.
As an example, if you’re looking at investing in apartments that have a cap rate of 7%, in comparison to other properties that have cap rates of 6.7%, 7.2%, and 7.5%, then your property’s cap rate is right in the middle and fairly comparable.
If the property had multiple points higher or lower than the others in the area, that should be a red flag.
Cap rates can also be a good general measure of the asset class and corresponding risk in general.
Assets with high cap rates tend to be in developing areas and those with lower rates may be in more established areas.
As with most investments, higher rate means higher risk as well.
What Passive Investors Need To Know About Cap Rates
Now that you understand what cap rates are, how they’re calculated, and how they’re used, do you really need them?
Maybe but not really.
As a passive investor, there are many data points that are far more important.
*The track record of the sponsorship team on a real estate syndication investment should be the top priority to take into consideration.
(You may want to go back and reread that last sentence as many times as it takes to sink in. It’s by far the most important in who I personally invest with.)
Otherwise, cap rates might carry weight in these two arenas:
#1 – Is the cap rate comparable to other assets in the area?
A strong sponsor team will have already evaluated the property to ensure the cap rate is comparable to others in the area, but you could double-check that your property isn’t 4% while others are 7%.
#2 – What’s the reversion cap rate?
Here’s one that might throw you for a loop – Reversion Cap Rate.
Sometimes the cap rate is referred to as the exit cap rate because the reversion cap rate is a measure of the:
- cap rate at the sale of the asset vs the cap rate at the time of purchase
If nothing else, take this knowledge with you– When evaluating a potential real estate syndication deal, be sure the reversion cap rate is at least 0.5% HIGHER than the current cap rate.
This means that the sponsors believe the property/ market conditions will be WORSE than it is now. In other words, they assume things will be in a less favorable condition than they are now and that the property will sell for a lower price.
If the current cap rate is 5%, then the reversion cap rate should be at least 5.5%. That will be a great indicator of conservative underwriting and that projections include the possibility of the market softening in upcoming years.
It’s similar in customer service. In our practice, I train my employees to “under promise and over deliver.” This is a win-win situation as patients return and refer their family/friends but also receive top notch customer service and care.
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What Is A Good Cap Rate For Rental Property Regarding Passive Investors?
At the end of the day, cap rate is a single measurement at a single point in time, based on the current performance of a given property.
Cap rates don’t measure the potential of an asset or how much you’ll receive in distributions.
As a passive investor, you definitely want to know what things mean and be on the look for this terminology while choosing an investment.
Beyond that, you will find that cap rates aren’t as important as some people make them out to be.
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