Understanding Real Estate The Cap Rate Game

One of the most used calculations you will see in real estate investing is a capitalization rate, also known as cap rate. But what does it really mean, and what should you use it for?

Choosing the right investment property is all about how much money you will receive compared to how much you invest. A good investment has the right balance between the expected income and the amount of risk.

The balance for each investor is different. Making the right investment decisions involves looking closely at each property and choosing one that fits all of your own criteria. A very common thing investors look at is a property’s cap rate.

What is a cap rate?

A capitalization rate (cap rate) is the percentage of the purchase price an investment property currently generates in net income. The cap rate is calculated before taking any loans or loan payments into account.

You can think of a cap rate as the return on investment (ROI) a real estate investment would provide if the property was purchased in cash and the income stayed exactly the same.

For example, if the purchase price of a property is $1,000,000 and the annual net operating income (NOI) is $50,000, the cap rate would be 5% because $50,000 is 5% of $1,000,000.

Why is a cap rate used?

Cap rates give an investor a general idea of how well a property performs. An investor may not spend time analyzing a property with a low cap rate, because they can easily tell it doesn’t provide the income they’re looking for.

The cap rate can also determine how much an investor wants to pay for a property. If your criteria involve a certain cap rate, you can figure out what the price would have to be to get that cap rate based on the current net income.

Lenders also look at cap rates when they’re underwriting a loan. It will help the lender decide if the income from the property is enough to cover the loan payments. It will also tell them how much money they can loan on the property.

What is a good cap rate?

Deciding what a good cap rate depends on many things. It depends on what your overall investment goals are, the property type, where it’s located, and many other things.

Ultimately, a good cap rate is one that provides a better return than other similar investments. If you’re looking at a property in an area with declining property values, a good cap rate will be much higher than the cap rate of a property in a growth market.

Higher risk properties may be appealing because of the potential returns, but there is a higher chance of things not going your way if the business plan is not properly executed.

What affects cap rates?

Cap rates fluctuate just like the interest on bonds or CDs, or the interest the bank charges for a mortgage. These changes fluctuate based on the market and the supply and demand. When many buyers are competing over the same properties, prices naturally go up. A higher price means a lower cap rate.

If sellers are having a hard time finding buyers for their investment properties, they usually start lowering the price. A lower price means a higher cap rate.

Mortgage interest rates also play a big role in cap rates. If mortgage rates increase, the spread, the difference between what an investor is paying for the money, and what they’re getting from the investment, is smaller. This means they’re making less money and naturally will demand higher cap rates which means lower sale prices.

Therefore it’s important to get attractive interest rates from your lender. The lower you’re paying in interest, the less vulnerable you are to changing rates and the higher your cash flow will be.

If you’re not able to get attractive interest rates, you might partner with an investor who can. Interest rates can have a big impact on the cash flow you receive every month and the equity you build.

The amount of new construction also affects cap rates. If more units are being built nearby, the demand for leasing apartment units may decrease. This can cause a higher vacancy rate and a lower rent rate sometimes.

How important is the cap rate?

A cap rate is just one thing to look at in an investment property. The cap rate gives you the ROI based on the current income and the assumption you’re paying cash. The reality is the NOI will change, you’ll leverage the investment, the real estate will appreciate, and you’ll build equity.

These factors play a huge role in the total return you’ll earn on your investment. Other factors you need to look at in terms of ROI.

  • Cash-on-cash return. This is the amount of cash in your pocket each year, after loan payments, compared to the amount of cash you put into the deal. This takes into account the loan on the property.
  • Internal rate of return (IRR). The IRR is a calculation that gives a better idea of what the ROI will be over the full term of the investment, instead of just the current time period like a cap rate
  • Equity multiple. Is the total cash distributions received from an investment divided by the total equity invested. Essentially, it’s how much money an investor could make on their initial investment. For instance, an equity multiple of 2.0x means that if you invest $100,000 on a project, you should expect to get back $200,000.

Is a good cap rate always a good investment?

The simple answer is no. It is a factor in determining if a property will generate cash flow, but does not tell you if an investment is good or not.

The most important things to look at when choosing an investment are:

  • Number of units. The more units a property has, the easier you can to increase the overall income.
  • Cash flow. The property must have a positive cash flow from month one. It has to be a good income producer.
  • Location. Must be in a great location that will continue to improve. You can’t pay too much for a great location.
  • Friendly debt. Banks must want to lend on it and be competitive with financing terms and interest rates.

What a cap rate should mean to you?

Calculating the cap rate is an important thing to do when looking at a real estate investment, but it definitely should not be the only metric used to make a purchase decision. There are a lot of other things that add up to tell the complete story of an investment property, you consider all of them before making your offer.

Knowing what a cap rate is will help you pick the right properties to look at, but make sure you can check all the boxes on a property you’re looking at. If you have specific criteria, you’re better being patient and waiting for the right property than jumping into something that’s not right for you.

Should you decide investing in individual properties is not for you, then investing with Vecno Capital will give you access to a professional team that analyzes hundreds of deals and invests in those with a well-balanced risk and reward (earnings).