Friday, September 16, 2011

Introduction To Capitalization Rates

Any seasoned real estate professional should be familiar with the term Capitalization Rate (or “Cap Rate” for short). But unfortunately, for both experienced investors and new investors alike, the true meaning of cap rate is often not well understood. The goal of this article is to try to explain cap rates in a way that everyone can fully understand – and internalize – both their meaning and their value to investors.

Before we discuss exactly what the Cap Rate is, let’s discuss why having an investment metric like Cap Rate is important...

Why Cap Rate is Important
Let’s say you were buying a property, and you wanted to know if the property were a good investment. What information would you ask the seller to determine if the property were one that you should buy? For many investors, the first question that comes to mind is, “What is the cash flow of the property?”

Note: For those not familiar with the term “cash flow,” it is the amount of money the investor will have left over after collecting the monthly income from the property and paying all the expenses (including property taxes, insurance, maintenance, mortgage, etc). So, a property with a $5000 per month cash flow will allow the property owner to pocket $60,000 per year.

While this seems like a reasonable question from the perspective of a potential buyer, there is one major problem with asking what the cash flow is on a property: the cash flow is going to be different for each potential buyer. This is because the cash flow is directly affected by the expenses associated with the property; the higher the expenses, the lower the cash flow.

And while a number of the expenses associated with a property are will not vary depending on the owner (for example, property taxes, insurance, maintenance, etc will likely be the same regardless of who owns the property), one key expense item will be very much dependent on the specific buyer – and that’s the debt service payments (mortgage payments).

The debt service payments are going to be directly related to the interest rate on the loan, the amortization period, and the down payment amount. Because two buyers will likely use different financing mechanisms, one is likely to have higher debt service payments than the other. And because cash flow decreases as expenses increase, the one who has higher debt service payments will have lower cash flow as well.

In fact, on the same property, one buyer who gets a loan with a low interest rate and a big down payment could have positive cash flow (i.e., he’ll make money each month on the property), while another buyers who gets a loan with a high interest rate and small down payment could have negative cash flow (i.e., he’ll lose money each month on the property).

Because my cash flow will likely be different than your cash flow on the same property, it doesn’t make sense to determine the value of the investment value of the property using this metric. This goes for several other popular metrics used to determine the investment value of the property as well – cash-on-cash return, total return, etc. That’s because these investment metrics are also specific to the buyer’s specific circumstances (debt service payment, tax bracket, etc).

So, if none of these metrics is a good measure of the value of the investment independent of the specific buyer, what is? That’s where the Cap Rate comes in...

The Cap Rate is a measure of a property’s investment potential, independent of the specific buyer. Regardless of who is evaluating the property, the Cap Rate will remain the same, and therefore two investors can do an apples-to-apples comparison of the same property using this measure.

Okay, so now you hopefully understand why the Cap Rate is an important metric when evaluating a property, but you still have no idea what it means…let’s jump into that now...

What Does the Cap Rate Mean?
In a nutshell, the Cap Rate is equivalent to the return on investment you would receive if you were to pay all cash for a property.
Here’s another way to think about that...

Most investors understand the basics of return on investment (ROI) for simple investments, like a Certificate of Deposit (CD). And most investors have a pretty good sense of what a good return on investment is. For example, with a typical CD, you might get a 5% return on your money. So, if you were to invest $100,000 in CD for one year, you would receive a 5% return (or $5000) at the end of the year.

Likewise, if you were to invest $100,000 in a stock market S&P fund for one year, you might expect to receive about an 8% return, or $8000 (assuming the S&P returned its long-time average amount in that year). People are very used to thinking about return on investment in this way – a simple return percentage that indicates how much your invested money will earn for you each year.

Unfortunately, calculating return on investment for a property is a little more complicated. This is because – unlike with a CD or a stock market investment where you pay for the total value of the asset up-front – with a property investment you often only pay for a portion of the asset up-front and the rest of the asset is paid for using a loan. For example, to buy $100,000 property, you may only have to put up $10,000. Because of this, figuring out the return on a property investment is more complicated.

But Cap Rate is our way of making the more complicated property investment look just as simple as a CD or stock market investment. Cap Rate assumes that you pay for the entire property up-front (just like the CD or stock market fund), and indicates your return on that property investment. In addition to allowing you to compare one property to another,

Cap Rate also allows you to compare a property investment to other investments. For example, if a $100,000 property had a 12% Cap Rate, the property would return $12,000 per year to someone who paid all cash for the property. Compare this to the 5% ($5000) that the CD returns and the 8% ($8000) that the stock market fund returns, and you see that the property investment is a pretty good deal (assuming you ignore all the extra work that goes into owning a property versus owning a CD or a stock fund).

Important: You should keep in mind that the Cap Rate isn’t necessarily the amount a real-life investor will make on a property. Because Cap Rate assumes that an investor pays 100% up-front for a property, and because an actual investor rarely pays 100% up-front, the actual return will differ from the Cap Rate of the property. In many cases, the actual return will be higher than the Cap Rate (one advantage of leverage).

How is the Cap Rate Calculated?
Now that we know what the Cap Rate means and why it’s important, let’s discuss how it’s calculated.
The cap rate is calculated as follows:

Cap Rate = Net Operating Income / Property Price

Note: For those not familiar with the term “net operating income” (or “NOI”), it is the amount of money the investor will have left over after collecting the monthly income from the property and paying all the expenses except for the debt service. Because the debt service amount should be the only property expense that is directly affected by the specific buyer, the NOI will be the same for all potential buyers.

As an example, let’s say that a specific property has the following characteristics:

Purchase Price: $500,000
Income Per Month: $15,000
Expenses Per Year: $60,000
Here is the cap rate for our example property...
First, calculate NOI:

NOI = Annual Income – Annual Expenses
= (12 x $15,000) – ($100,000) = $80,000

Then calculate Cap Rate:

Cap Rate = NOI / Property Price
= $80,000 / $500,000 = 16%

The next question you might ask is, “What is a good Cap Rate?” While it really depends on the area of the country you’re in, in general, most areas see maximum Cap Rates in the 8-12% range. And just like the value of single family houses are based on the prices of comparable houses in the area, the value of larger investment properties are usually based on the Cap Rate of comparable investment properties in the area.

So, if the average Cap Rate in your area is 10%, you should be looking for at least a 10% Cap Rate for your property (barring other more complex situations and considerations).
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