If you are new to Real Estate investing, multi-family units, ADU, and high desirable area are what you have been told to look at. Though it’s absolutely right to do so, there’s much more to analyze beyond those. At Chad Vo Real Estate, our goal in the long run is to convert all of our clients into seasoned real estate investors. And as seasoned investors, capitalization rate (or cap rate for short) is something that just cannot be ignored or skipped.
What is Capitalization Rate?
Cap rate, expressed by percentage, is one of the most basic and commonly used metric to either determine on an acquisition strategy or compare investment properties. It indicates the expected rate of return of the property against its asset value.
Depending the market, a “good” capitalization rate typically falls between 5% and 10%.
How to Calculate Capitalization Rate
There are many versions of cap rate calculation and it’s all depending on the use cases and how thorough one wishes to be. For most cases, cap rates are used to compare investment properties. Theoretically speaking, the higher the cap rate value is, the more profitable that investment may yield. For the sake of simplicity, we will use the basic model here for easier understanding.
Cap rate can be calculated using annual net operating income (NOI) divided by the current market value of the property. NOI can be determined by subtracting all operational costs except mortgage payments (i.e property magement, utilities, tax, etc.) from gross revenue costs.
Cap Rate = Net Operating Income / Property Market Value
For example, a property worth $100,000 is generating $1,000 in monthly rent or $12,000 annual income. Meanwhile, the total operating expenses equate to be $7,200. The NOI for the year is $4,800 ($12,000 – $7,200) and the cap rate is estimated to be 4.8% ($4,800 / $100,000).
Notes for Investors
Since the main use case for cap rate is to compare investment properties with each other, it is important to eliminate as many biases as possible because there’s no such thing as 2 identical properties.
The biases typically occur when investors calculate the property’s NOI. Though we did mention monthly mortgage should not be included in the calculation, the loan cost such as closing costs & brokerage fees MUST be included because those are considered business operational expenses. And so is rehabilitation cost. Beginner investors typically fall for these biases and end up with false analysis.
Therefore, when using cap rate as the main vehicle to analyze the rate of return, all costs and operating margin must be the same for all properties to eliminate as many biases as possible.
Other Factors that Affect Capitalization Rate!
Just like purchasing a primary home, besides the initial capital and the purchase price, there are many other factors that will affect one’s decision. Since cap rate associates with an investment property, its location and surrounding factors (such as neighborhood and school score, traffic, local economy, etc.) have huge influence on the underlying calculations, which are approached differently depending on the investor.
A great example would be a subject property in “below average” condition but is located in a neighborhood that’s considered safe, close to high-rated school district, and in a well-developed economic area with big corporates coming to town. Even though it doesn’t seem attractive to most at first, some investors may see greater opportunity in this property and make a long-run investment.
Of course, the overly-simplified example above is for educational purpose only to demonstrate how cap rate is more than just reading historical data from the sellers or from your own research.
The Good, The Bad, and The Ugly of Capitalization Rate
Just like commercial real estate and other type of asset, cap rate is used to measure and compare the returns of different investments. In this case, it’s meant for among investment properties. Like mentioning above, the higher the cap rate the more likely investors will allocate resources toward that investment.
Sounds good right? Of course not, even though I am a huge advocate of using cap rate as one of the main methods to measure the potential ROI, there are lots of nuances here.
The Good
Let’s go over the great part first!
Cap Rate is considered one of the most useful and popular KPIs (Key Performance Indicator) that investment bankers, real estate investors, and asset management firms use to make a decision if either they or their clients should move forward with a deal or not. Therefore, you can safely trust that this is not a bullsh*t method.
Furthermore, if you are a data maniac like I am and like to keep track of all historical data and create different queries and pivot tables, cap rate can be very helpful to predict trends on how the rental market of subject properties are going.
Sadly, just like any other data exercises, there are always challenges and this is also not an exception.
The Bad and The Ugly
It’s called trend and income prediction for a reason. Just like other analyses, we can sit here and calculate one’s cap rate all days and there is absolutely no guarantee on the outcome of an investment. It can either do extremely well or relatively bad and no one will know 100% for sure.
There will always a certain degree of risk associating with an investment property that we can never accurately account for such as the level of depreciation, amount of expenses, and unexpected events that are out of our control such as natural disaster, local employers going out of businesses, etc. These elements, though can never be predicted, should always be expected outside of a cap rate calculation.
And most importantly, cap rate is only a useful metric for the traditional long-term rental strategy. It’s much less inaccurate when it comes to short-term rental strategy or STR (Airbnb, Vrbo, etc.). If you plan to invest in an STR property, do consider using a discounted cash flow analysis instead, which we will cover in the future.
In Conclusion
A higher cap rate indicates the higher chance a return can be but there will always be other factors affecting a decision and cap rate’s calculate itself.
At Chad Vo Real Estate, it is our job to provide these educational pieces to our clients to ensure they fully understand how a rental property investment works. And for all intelligent and strategic investors out there, understanding how cap rate works and its nuances is a must. Like previously mentioned, our lean team is not only a bunch of real estate brokers but we are also investors and analysts ourselves that assist many investors acquiring their first rental properties and expanding their portfolio.
If you are interested to learn more on real estate investing and / or need our help, do reach out to info@chadvorealestate.com for further discussion.
If you are shy, you can also read our guidelines on how you can acquire your first rental property here.
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