If you have ever looked into investing in multifamily buildings, or other commercial properties, you have probably heard of Capitalization Rate. Known by its more common name, “cap rate,” this term is used quite frequently in the buying and selling of investment and commercial properties. For those who have been investing in commercial properties, this term is probably quite familiar. For all others who would like to learn more about cap rate and how it’s used, below is a quick guide that you may find helpful.
What is Cap Rate
Property Metrics defines cap rate as “the ratio of Net Operating Income (NOI) to property asset value.” Some may prefer the definition provided by Investopedia, which is “the rate of return on a real estate investment property based on the income that the property is expected to generate.” Cap rate is a good method for comparing income producing properties, even if these properties are not similar. The formula for calculating a cap rate is actually pretty simple in theory: Cap Rate = Net Operating Income / Current Market Value. In order to calculate cap rate, you need to use 3 assumptions:
- You are buying the property with all cash and therefore do not have a mortgage to pay
- You are generating a regular income on a yearly basis
- There are expenses that are associated with the property
Net Operating Income
Before you can calculate your cap rate, you need to first calculate your NOI. This is simply done by subtracting your operating expenses from your operating income. Since we are mainly focusing on residential units, the operating income will consist of the rent you collect. When you start looking at other commercial opportunities, the income you collect can take on various forms. Unfortunately, calculating operating expenses is not quite as simple. Expenses that should be included are property taxes, utilities, insurance, vacancy, maintenance, and property management. Even though you may not experience a vacancy or maintenance every month, it is a good rule of thumb to always calculate these expenses into your numbers, as you will experience them at some point. Likewise with property management, even if you plan on managing the property yourself, it may be best to account for this expense as you never know what the future may hold.
Calculating Cap Rate
For a clear understanding of how to calculate a capitalization rate, let’s go through an example. Let’s say you purchase a duplex in Ventura for $500,000. Remembering the assumptions from above, you are buying this duplex with all cash and will not have a mortgage. We will then assume that you are able to rent out one unit for $2000 a month, the other unit for $1000 a month, and that your total expenses are $1000 a month. This would mean that your total income would be $(2000 + 1000) = $3000 a month. If you subtract your $1000 of expenses per month, your profit comes out to $2000 a month. If you calculate that profit for the whole year, you will come up with $24,000 a year. In order to calculate our cap rate, we will divide net operating income ($24,000 in this case) by the current market value ($500,000 in this case). If we do this, we come up with 0.048, or a cap rate of 4.8%.
How to Use Cap Rate
As mentioned above, cap rate is a good way for an investor to compare investment opportunities. If one building is selling for $500,000 and the rents are $5,000 a month, but another building is selling for $600,000 but the rents are $5500 a month, it is difficult to tell which one is a better deal. On top of that, without knowing what the expenses are, you aren’t exactly comparing apples to apples. However, if you were told the first building has a cap rate of 4.5% and the second building has a cap rate of 5.0%, you immediately know that the second building offers a better rate of return.
Drawbacks of cap rate
Knowing the capitalization rate is great, but there are also some drawbacks. If someone is selling a property and providing you with a cap rate, you want to make sure you verify the numbers that are going into the calculation. The seller may want to make their property look more attractive than it really is and use “projected” numbers rather than “actual” numbers. Also, cap rate does not take into account any “value-add” opportunities the building might present. It could be possible that the current rents are below market value or that additional units could be added onto the building or lot. These would not be reflected in the current cap rate calculation. Finally, and maybe most importantly in a location like Ventura County, cap rate does not factor in appreciation. Based on historical numbers, prices in Southern California have always risen over time. If you are able to hold onto your property for the long term, you have the potential of seeing increased profits due to appreciation that is not calculated in the cap rate.