Capitalization Rate or “Cap Rate”
Cap rate is a term that can be very confusing to most people. There are different calculations that can be used to determine cap rate and the expectation of income. It is my opinion that if you are buying real estate for investment purpose, you should make sure you are always comparing “apples to apples”! You really don’t need to concern yourself with the cap rate if you are not going to use this property for income.
So What’s the Bottom Line?
The simple explanation for Cap Rate is Net Operating Income divided by the Property Asset Value or Market Value – (NOI / Property Asset Value). Because rental properties are usually very different, it can be difficult to determine the fair market value of a property. A property with lower expenses and higher rental potential will command more on the market than a property with higher expense and lower rents. When we buy a home, this is a very personal choice; not so much when you are buying investment property. Cap Rate helps to determine what the value of the property is to you. In other words, what type of annual return do you want to get.
Sounds simple enough right? – Not So Fast!
Where you can get into the weeds is when you start comparing properties. If you do not do the assessment of the cap rate yourself, find a person you trust who can compare and vet the data and will do it the same way on every investment opportunity.
Tip: You might want to use a form or “cheat sheet” that has all the income and expense variables listed so that you do not miss any categories. Homes or duplexes will be much easier to calculate than dealing with commercial properties or apartment buildings. With commercial real estate, there may be added costs or expense such as, Management company, marketing, permit fees and taxes as well as other costs that you may not be aware of in the local area. It is always a good idea to have a professional help you specify the finer points of a possible purchase.
Rental History vs NO Rental History
If you have a rental history and expense history, the cap rate will be more accurate than any estimate. You also need to figure in the vacancy rate for your area. Here is an example. In West Sedona, it is sometimes very difficult to find a home to rent. This would indicate that the vacancy rate may be below the national average of 7%. It is important to figure in the vacancy rate. A reliable property management and rental company can give you that information. In Sedona and the Verde Valley I can help with that information. Contact Sheri Sperry. Also, if you have a property where you will need a property manager and are considering a tenant as the property manager, any discount in rent should be included in your operating expense. Check with your financial advisor to determine the appropriate expense. After all, you would have to hire a property manager.
What Is An Acceptable Cap Rate?
There is no simple answer in this quest to find the right property. Only you can determine what may be acceptable. Basically, cap rate helps you determine what kind of annual return you will get on the money you are investing in the property. It can also determine what you should pay for the property. The formulas below will assist you.
My personal opinion is that a return of less than 5% could put your investment at risk and require infusing more money into the property if something happens that is unexpected. Better yet, a 7% to 9% Cap Rate is less risky and is preferred by investors. Some refer to infusing money into the property as a capital call. This is especially true when there are other investors involved such as in some sort of partnership or corporation. It may involve a substantial repair, remodel or build out for a tenant. If there is very little in reserve, the money will need to be funded using a capital call.
The higher the return, the more value the property holds. This also helps to keep more in reserve to minimize the risk of a capital call.
Net Operating Income (NOI) = Annual Rent minus Annual Expense
Cap Rate = NOI divided by Market Value or Property Assessed Value
Property Assessed Value = Annual Income divided by Cap Rate
Please contact me to discuss how I can help you with all of your real estate needs. I want to help you navigate through the process. I love helping people buy and sell homes – it’s my expertise and what I do! See more here.