When deciding what property to purchase as an investor, it is useful to compare properties by calculating the cap rate for each property being compared. Cap rate is a term used in the real estate industry. It is short for capitalization rate. Cap rate measures income from a real estate minus expenses (other than interest) all divided by price. Thus, cap rate can be considered to be a measure of an investor’s rate of return from rent in a single year.
What is Capitalization Rate?
The fundamental concept of Capitalization rate revolves around a single year’s rate of return for a property and thus allows a comparison of income potential of one property versus another property. It is one of several tools in determining whether a particular property is a good investment. Let’s dive deeper to understand what Cap rate actually is.
The fundamental concept of Capitalization rate revolves around a single year’s rate of return for a property and thus allows a comparison of income potential of one property versus another property. It is one of several tools in determining whether a particular property is a good investment. Let’s dive deeper to understand what Cap rate actually is.
Understanding the Capitalization Rate
For example, let say that the current asking price of a rental income property is $500,000. This property is currently rented out for $1,000 per month. Vacancy rate in your city is 5%. The building is very new so only $2000 every year is needed for the maintenance of the house.
So gross income is $1000*12 = $12,000 while net income is $12,000 – $600 vacancy loss – $2,000 repairs = $9400 . So the cap rate for this property year is $9400 / $500,000 = 0.0188 or 1.8%. This is very poor indeed. An investor can get a better return in the stock market without taking the kinds of risks that are involved in real estate, of potential damage to the property. After paying interest on a loan, this property would have negative cash flow. An investor should seek a cap rate that is well above the interest on a loan. A property that provides a 9% cap rate is a decent investment, for example.
Vacancy rates are different in different cities and should be taken into consideration. A property in a city with a high vacancy rate will have a lower cap rate than a property in a city with a lower vacancy rate. You many not have a vacancy at all in a particular year, but you are likely to have a longer turn over between tenants in a high vacancy market than in a low vacancy market.
Determining cap rate helps you gauge the real value of a potential purchase versus other alternatives. .
Capitalization Rate Formula
Cap rate calculations do not consider interest expenses so can be thought of as the rate of return from rents in an unleveraged property .
The equation for capitalization rate is
| Capitalization Rate = Net Operating Income / Value of the Asset |
Cap rate signifies a property’s annual rate of return from rent (excluding appreciation) when bought in all-cash.
How to Calculate Real Estate Cap Rate?
To calculate the capitalization rate, divide the property’s net operating income by the current market value.
The net income is the income from rent after deducting the regular expenses of the property incurred by the owner. The cap rate calculation for real estate might seem easy at first glance but has slight variations. For example, how can a buyer determine what repairs to expect each year? One option is to estimate that repair expenses will be about 30% of rent.
Another option, to get more accurate numbers, is to ask the seller to provide two or three years of actual income and expense statements. Then the actual expenses over two or three years can be averaged. However, sellers will often provide these numbers when they receive an offer but a buyer should request these and do an accurate calculation during an inspection period.
Be aware that some real estate agents tend to overstate income and understate expenses in listings. Real estate listings cannot be relied upon for accurate income and expense information. In a fourplex that has four identical units with different rent amounts charged for each unit, it is common to see a real estate listing that uses the highest rent of any of the units times four as the stated monthly rent in a listing. That number should not be used in calculating cap rate. The actual current rents should be used in evaluating a property, not pro-forma, ideal world rents. Just because you might be able to get more rent does not mean you will. Tenants will have leases and rents cannot be raised immediately. Tenants may have been given move-in incentives just as a first month’s rent free, thus lowering the actual effective annual rent.
The buyer should ask for two or three years of Schedule Es, not just any income and expense statements. Schedule Es are the relevant portions of a seller’s tax return. Income numbers would include vacancies. They would reflect the actual income an owner received after vacancy loss. All expenses would also be reflected, not just taxes and insurance. An owner is not going to understate expenses to the IRS or overstate expenses to the IRS. Note that Schedule Es do not include capitalized expenses such as for new roofs, so to some extent, Schedule Es do not present all expenses. Ask for the list of assets that are being depreciated, in addition to the Schedule Es.
How To Use Cap Rates To Compare Potential Purchases
Generally speaking, a property with a higher cap rate is a better investment than a property with a lower cap rate. However, that assumes that you have correctly estimated repair expenses. If you are just estimating expenses as 30% of rent in calculating cap rate, older properties will always appear to be better investments than newer properties. However, older properties can have very high repair expenses, and may need new plumbing, electrical, foundation work, furnace work, asbestos mitigation, sewer pipe replacement, etc. Therefore, cap rate calculations should be used to compare potential investment properties of similar age only.
In addition to comparing cap rates when evaluating alternative investment possibilities, it is often useful to compare price per square foot. Keep in mind that price per square foot is only useful when comparing properties of similar age and quality. An extra bathroom adds a lot of value to a house even if the square footage is the same as another house. For this reason, cap rate is a much more useful tool to use when comparing alternative investment properties than price per square foot.