What Every Passive Investor Should Know About Cap Rates
If you've invested in residential real estate, you're probably familiar with terms like rental income, hard money loan, and Debt-to-Income Ratio, just to name a few. But when you enter the realm of commercial real estate, you'll notice that other terminology, such as "cap rate," being tossed around as if everyone knows what they imply.
It's okay to not know what a cap rate is or what it's used for. It can be difficult to grasp at first, but not impossible to calculate. As a passive investor, you won't have to perform any of the tedious work to determine cap rates, but it's useful to understand what they are.
What are Cap Rates?
Cap rate is an abbreviation for capitalization rate and is used to describe the projected rate of return on a specific property. Cap rate is used by investors to determine their prospective ROI (Return on Investment) for a specific asset, and is expressed as a percentage.
When someone says a property has a 5% cap rate or that assets in a certain area are trading around a 5-cap, they are referring to the property's return.
How Are Cap Rates Calculated?
A cap rate can be calculated in a variety of ways, so always inquire how it was determined.
Most cap rates are calculated by dividing net operating income by market value. For clarity, here's an example:
Let’s say we purchase a property with a current market value of $1 million. And in the past year, the property brought in $100,000 in rental income.
After paying $50,000 in expenses, we end-up with a calculation of $50,000 - the Net Operating Income (NOI). We take the NOI of $50,000 and divide that by the market value of the property.
$50,0000 / $1,000,000 = 5%
NOI/Property Value = Property Cap Rate
This means if we purchased the property for $1 million right now, we could expect to earn $50,000 net income over the course of one year. This, loosely reflects our Return on Investment or ROI.
One way to think of it is that it would take 20 years of returns at $50,000 to recoup your $1 million initial investment.
$50,000 x 20 = $1,000,000
If the property generated $150,000, with the same $50,000 in expenses, the cap rate calculation of $100,000 (NOI) divided by $1 million, would equal 10%. In that case, it would only take 10 years to recoup your initial investment value.
$100,000 / $1,000,000 = 10%
NOI/Property Value = Property Cap Rate
The greater the cap rate, the faster you'll recoup your investment capital and the better the investment. The good news is that you don't have to be an expert in every detail to be a successful passive investor.
How are Cap Rates Used?
Some investors place a high value on cap rates and seek investments with high cap rates. However, that is merely one data point on an asset, and you must also take into consideration that one type of commercial real estate can be traded at a different cap rate from another type. Also note that cap rates do not account for other considerations such as loans or the time value of money.
When comparing different properties in the same market, cap rates can be very useful.
As an example, if you’re looking at apartments that have a cap rate of 5%, in comparison to other properties that have cap rates of 4.7%, 5.2%, and 5.5%, your property’s cap rate is right in the middle and fairly comparable to the rest.
If the property had multiple points higher or lower than the others in the area, that should be a red flag.
Cap rates can also be used as a generic measure of the asset class and its associated risk. Higher cap rate assets tend to be in developing areas, while lower rate assets may be in more established places. Higher rates, as with other investments, imply higher risk.
Do you need cap rates now that you've learned what they are, how they're calculated, and how they're used?
There are other data points that are significantly more important to a passive investor; such as the calculated returns on your investment, the hold period, distributions and splits, and the sponsor team you're working with.
Cap rate may also carry weight in these two arenas:
#1 – Is the cap rate comparable to other assets in the area?
A strong sponsor team will have already evaluated the property to ensure the cap rate is comparable to others in the area, but you could double-check that your property isn't’ 4% while others are 7%.
#2 – What’s the reversion cap rate?
Here’s one that might throw you for a loop - Reversion Cap Rate.
Sometimes the cap rate is referred to as the exit cap rate because the reversion cap rate is a measure of the cap rate at the sale of the asset, versus the cap rate at the time you purchased the asset.
Take this knowledge with you if nothing else: When reviewing a potential real estate syndication agreement, ensure that the reversion cap rate is at least 0.5% higher than the current cap rate; such as adding 10 basis points per year on a 5 year hold.
This suggests that the sponsors is taking into account that the property and/or market conditions will deteriorate. In other words, they calculate an expectation that the property would be in worse shape than it is now (or after improvements) and may sell at a higher cap rate.
If the current cap rate is 5%, then the reversion cap rates should be at least 5.5%. That will be a great indicator of conservative underwriting and that projections include the possibility of the market softening in up coming years.
Cap Rates - Final Verdict
Cap rate is, in the end, just one measurement made at one specific time based on the performance of a certain property. Cap rates don't account for an asset's potential or the amount of distributions you'll get.
As a passive investor, it is imperative that you understand the terminology used and keep an eye out for it while selecting investments. Aside from that, you will find that capitalization rates are one of the last things to be concerned with.
Return on Investment (ROI): ROI is a simple calculation that shows the amount an investment returns compared to the initial investment amount.