Cap Rates Debunked: What's in a Cap Rate?

Post by 
Dan Croce

Introduction

For new investors in real estate, picking the right property to start an investment portfolio can be a daunting task. After all, purchasing an investment property is no small feat. Any time you’re putting your money on the line, it’s important to make an informed decision. As such, you may be asking, “How can I determine which property will generate the best return on my investment?” or “What metrics are important to look at to make my decision?”

One key metric that investors use is the capitalization rate, or “cap rate,” of a property. Cap rates are sometimes thought of as a complicated term that only advanced real estate investors can understand and apply. However, in this article, we’ll explain that the cap rate is actually quite easy to comprehend and compute. 

The cap rate is a metric that measures the expected year one return generated by an investment property without using any debt. This expected return can be thought of as similar to the annual yield of a bond investment. It expresses the relationship between the expected yearly net operating income and the property’s purchase price.  Big picture: cap rate is a snapshot of the property’s ability to generate an immediate return for the investor.

Helpful Context

Before diving further into the nuts and bolts of how the cap rate is computed, there are a few important pieces of information to learn.

First, we have to understand Net Operating Income (NOI). Net Operating Income is simply operating income minus operating expenses. Operating income is income generated through the asset’s operations. For an investment property, this will most commonly be rental income, but could also include ancillary revenue streams such as laundry income or vending machine income. Operating expenses will include any expenses incurred managing the property such as property taxes, insurance, management and administration expenses, maintenance costs, and utilities.

Next, since the cap rate does not account for debt that may be used to finance a purchase, it also does not factor in any financing costs for the asset; for properties, this will be mortgage payments. The technical term for a metric that does not consider debt is “unlevered.” If a metric does consider financing costs, it is levered. Therefore, cap rate is an unlevered metric. 

Finally, the cap rate does not account for any changes in a property’s future cash flows. It is simply a measure of today’s net income stream in relation to the purchase price, and does not take into account the fact that a property’s future cash flows may vary significantly - particularly in value-add scenarios where the investor plans to improve the property and increase rents. The cap rate is one factor that should be considered when evaluating a potential investment, but it’s certainly not the only one.

How is it Calculated?

There are two primary ways to calculate the cap rate of a property. The first method, and the most simplistic,  is the ratio of the property’s net operating income to the proposed purchase price. For this method, the price the investor is going to pay for the property is used to calculate the cap rate. So, if a property produces $75,000 in net operating income and the proposed price is $1 million, then the cap rate is 7.50%. As the net operating income increases, the cap rate increases; as the proposed purchase price increases, the cap rate decreases. 

An alternative method, which results in a more comprehensive return on investment projection, is the ratio of the property’s net operating income to total capital invested. This method is similar to using purchase price, but it also accounts for capital invested for improvements to the property, cash reserves, and closing costs. This method provides a more conservative and realistic picture for an investor when trying to determine the property’s expected rate of return. As such, Birgo Capital typically utilities this calculation when performing investment analysis for potential acquisitions.  If we utilize the same example as above, but assume that $100,000 will need to be invested into improvements, cash reserves, and closing costs, our cap rate goes from 7.50% to 6.81%.

What is it Used For?

Ultimately, Birgo Capital’s view is that the cap rate is a tool that is used to measure two things: risk and expected return.

With respect to risk, simply put, an investment that poses greater risks will require greater returns, and will therefore command a higher cap rate. Another way to think of the formula for the cap rate is that it is the sum of the risk free rate of return plus the risk premium that an investor assigns to the particular property. If the risk free rate of return is 2% and an investor requires an additional 3% of return for the risk of investing in a very attractive apartment building in a major international city, then that building will have a cap rate of 5%. However, if the investor requires an additional 6% of return over the risk free rate because the building is located in a less populous area or has more collection concerns, then the cap rate would be 8%. As risk increases, so does the required return -- and so does the cap rate. For Birgo Capital, our best deals are where we believe that the asset is mispriced -- these are situations wherein the seller requires a cap rate that is fairly high, but we don’t believe there is disproportionate risk to the investment.

As for measuring expected return, there is generally an inverse correlation between expected appreciation and cap rate. If we are targeting a certain expected total return on investment, and a larger portion of that return is going to be achieved through appreciation, then we can accept a lower cap rate and achieve the target total return. However, if we expect very little appreciation, then a higher cap rate is needed to achieve the same level of return. 

For example, if we are seeking to achieve a total unlevered return on investment of 10%, and we expect the property to appreciate in value by 4% per year, then we would need to buy at a 6% cap rate in order to achieve our target return of 10%. Conversely, if we only expect the property to appreciate by 2%, then we would need the cap rate on purchase to be 8% in order to have a total return of 10%.

Conclusion

In summary, the cap rate is an extremely helpful tool of analysis to determine the expected return and expected risk of a particular investment. This introductory guide exposes you to a few different angles on the calculation and utilization of the cap rate, but there are many more approaches and ways to think about this metric. However, in general, its straightforward calculation and ease of use make it a universally accepted first-glance tool for evaluating real estate investments. 

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