What Is A Good Cap Rate And Why It Matters
What Is A Good Cap Rate?
When I first started passively investing in real estate a few years ago as a periodontist, I began with zero real estate experience. This is similar to the many doctors turned real estate investors I speak with weekly.
As someone that loves to read, this didn’t bother me too much. The more I learned, the more I realized that I had to familiarize myself with some of the common real estate terminology such as ARM, LTV, NOI, Cash on Cash Return (CoC) and Cap rate.
Understanding how to evaluate potential investment properties to invest in starts with understanding the right calculations.
If you don’t understand the numbers and how to factor the costs and potential gains, then don’t invest a dime until you do.
When I started investing in multifamily syndications, the term “cap rate” was tossed around quite frequently so I naturally wanted to learn why the cap rate is important.
It can be both hard to understand and calculate. The good news is that as a passive investor, you don’t need to do the tedious work of calculating them.
You do, however, need to have a basic understanding of what they are and mean for your investment to help you determine your level of risk.
In this article, we’ll go over what a cap rate is, how it’s calculated, what it’s used for, and, perhaps most importantly, what you need to know about them as a passive investor in a real estate syndication.
Let’s get going…
What’s A Cap Rate?
Cap rate, known more formally as capitalization rate, is used in commercial real estate to indicate the rate of return that a property is expected to generate.
It’s based on a ratio of the current income to the market value of the property.
You might hear people say that a property has a cap rate of 6%, or that assets in a given area are trading around at a 6-cap.
Let’s talk a little about what this means, and how people arrive at these numbers.
How To Calculate
To calculate the cap rate formula of a property, you simply divide the Net Operating Income (NOI) by the property’s value.
One thing that you may notice is that this formula does NOT include a mortgage or interest payment.
Excluding debt is part of why a cap rate is so useful. The formula is focused on the property alone and not the financing used to buy the property.
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Let’s use the example of an apartment complex here in Louisiana:
- Property value = $1 million
- Property brings in $100,000 in income
- Operating expenses = $50,000
- Net operating income (NOI) = $50,000 (Income – expenses)
Now that we know the NOI and property’s value, we can calculate the cap rate:
$50,000/ $1,000,000 = 5% cap rate
If we pull the trigger and purchase this apartment building with $1 million in cash right now (remember that this doesn’t take any debt into consideration), we could expect to get $50,000 in net income over the course of a year.
Basically this would be your ROI (return on investment).
By knowing the 5% cap, we now know that it’d take 20 years of $50,000 a year to recoup the initial $1 million investment.
Here’s a different scenario using the same example:
- Annual income = $150,000
- Same expenses = $50,000
- cap rate = $100,000 / $1,000,000
- cap rate = 10%
In this case, it would only take 10 years to recoup the initial $1 million investment which would theoretically be a better return on your investment.
Typically, a high cap rate means you’re getting a better deal because the investment is generating more income for the amount you’re investing into the property.
A lower cap rate generally means that you’re paying more and getting lower returns.
How Are Cap Rates Used?
Some investors put a lot of weight into cap rates. For example, they only look for properties that have a cap rate of 8% or higher.
However, keep in mind that a cap rate is just a single point of measure, and at one given point in time.
Cap rates do not take into account leverage (i.e., any loans you’re taking out to purchase the property) or the time value of money (i.e., it assumes you’re getting all the returns at one point in time).
Cap rates are most useful when comparing different properties in a given market. For example, let’s say that you are looking at an apartment building that’s selling for a 7% cap.
When looking at other buildings in the immediate area, you see three additional properties at cap rates of:
This tells you that the building you’re looking at is right in the middle and is fairly comparable to the returns and purchase prices of the others in the area.
On the flip side, if you notice that the majority of properties in the area of interest are around 4% then you should proceed with caution.
It should make you ask yourself why the property you’re looking at is selling for such a low price in comparison to the amount of income it can generate.
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What’s A Good Cap Rate For Rental Property?
It can be difficult to say exactly what a good cap rate looks like. The answer depends largely on the market that you’re in as well as the specific goals you have as an investor.
These rates can also be a good general measure of the asset class and corresponding risk. Sometimes they’ve become synonymous with risk evaluation.
- Assets with higher cap rates tend to be in more developing areas and thus come with more risk.
- Assets with lower cap rates tend to be in more stable areas, often with greater demand, and thus can command higher prices.
That’s why you’ll often hear about them compressing or getting lower in hot markets like the San Francisco Bay Area. Because there’s so much demand, people are willing to pay higher prices in exchange for lower rates of return, thus driving the overall rates in that market down.
With anything else, it’s going to boil down to you and what’s best for your investment comfort level. You’ve got to identify how much risk you’re comfortable taking on.
Remember that a lower cap rate implies lower risk, while a higher cap rate implies higher risk.
The general consensus seems that a cap rate between 4 – 10% may be considered a “good” investment.
Bear in mind that whenever you’re deciding on which real estate investment you should invest in, there’s no single metric that will give you all the information you need.