If you're new to real estate investment, capitalization rate, or cap rate, is one of the most common and essential calculations you'll need to know to help you make an educated investment choice. It can help you identify the right investment property when you use it as part of a proper investment evaluation.
Here's what you need to know about cap rates to make an investment that minimizes risk and maximizes potential profits.
What is Cap Rate?
A cap rate presents the potential rate of return and income yield on a real estate investment. There are a few variations on calculating cap rate based on what you want to learn about a property, but, at a high level, a cap rate tells you how much of an operating return is possible for a specific investment property in a year, assuming an all-cash purchase.
Not including mortgage interest in a cap rate calculation allows you to quickly focus on the financial merits of a potential investment property.Further, it allows you to compare various potential investments with different leverage profiles to each other on an "unlevered" basis.
While not all real estate professionals will provide you with this information, you can utilize a platform that provides the cap rate on each of their identified top properties as part of a detailed investment report, like Konfidis does. The Konfidis real estate investment platform not only identifies the cap rate of each opportunity, but it helps you evaluate and compare properties and their team is available to answer any questions you may have about cap rates and the role they might play in your investment.
Cap rate is calculated by dividing a rental property's net operating income by its current market value. Mathematically it looks like this:
Cap Rate = Net Operating Income / Current Market Value
To get your predicted net operating income, deduct the operating expenses you will incur to rent out the property from the expected income based on its current rental rates. Those expenses can include:
Property taxes.
Condo and maintenance fees.
Repairs and upkeep.
Rental property insurance plans.
Utilities.
You may also have to include any initial renovation costs if you haven't accounted for them anywhere else, and you'll need the most current data you can find to calculate an accurate cap rate as real estate prices fluctuate over the course of a year.
How Do You Use a Cap Rate?
To understand how to use the capitalization rate, let's do a couple of example calculations.
If property A will return $100,000 net operating income over a year and it's currently worth $1,000,000, while property B only nets $70,000 a year net operating income and its current market value is $850,000, their respective cap rates are:
Property A Cap Rate: $100,000 / $1,000,000 = 10%
Property B Cap Rate: $70,000 / $850,000 = 8.2%
What are these percentages telling us? They're a quick calculation of how much, as a percentage, your ROI would roughly be for each investment property in a year, assuming you do not use a mortgage. So property A will produce an operating yield (or return) of 10% per year on your $1,000,000 investment, while property B will earn you 8.2% of your $850,000 investment per year.
So which investment gives you better bang for your buck? It might seem obvious that a 10% ROI is better. But in reality, the answer is: it depends. While cap rates are a quick and easy evaluation tool, they only provide a snapshot of how well a property performed in one year.
A cap rate is helpful, assuming that the rental income of a property has been consistent over the years. If not, more investigation is needed if a property's income fluctuates or suddenly spiked (or dropped) in one year.
There's also the question of risk. Like most investments, the higher the rate of return, generally, the higher the risk. While a 10% return seems a better investment than 8.2%, you're risking $1M vs $8.5K. Again, further investigation is needed to discover how stable a rate of return is in a given neighborhood and what kind of future is predicted for it - another reason to always consult an expert before making investment decisions.
