Cap Rate - 3 Simple Uses
What is Cap Rate?
Capitalization Rate, often referred to as "Cap Rate" by investors, is the ratio of net operating income (NOI) for an asset, to the asset's cost (most often real estate is the asset in question). When looking to buy real estate, Cap Rate can be used to do quick valuations on properties, or calculate the typical return of other properties that are comparable to the one you are looking at buying. To find the cap rate you use this formula:
C (Cap Rate) = NOI (net operating income)
V (Value/Cost)
So for example, if a 2 bedroom condo you are looking at will generate about $12,000 a year in net rental income (the NOI) per year, and the sales price (sold) of the property was $300,000. We can see the cap rate would be 4%. The forumla would look something like this:
(C) 4% = (NOI) $12,000
(V) $300,000
Do this on enough properties and you can start to get a good feel for what average cap rates are in different areas around you.
Cap Rate and Finding Value
Real estate investments are valued based on all kinds of criteria. Things like location, comparable property sales prices, land value, and the replacement cost to re-build the existing structure. Using the cap rate can give a simpler valuation with less variables, this can be handy when evaluating large numbers of properties. You can use cap rate to estimate value, or purchase price in this way:
(V) $171,428 = (NOI) $12,000
(C) .07 (estimated)
So if you do your due diligence and discover the average cap rate for properties you are looking at is 7%, and the income (NOI) of a particular property is around $12,000, then you can quickly estimate the average value of a property (using your estimated cap rate) to be around $171,428.
Cap Rate to Compare Investments
If you find properties that are cash flowing around $12,000, and similar properties have sold with a cap rate around 7%, then you know that $171K is an average price for that type of property.
If you are finding lower cap rates, that can mean less market risk, since the property is in demand. Higher cap rates usually show more market risk, as the property is not in as much demand. Properties in higher demand, often have positive factors that are driving the price of the property up, lowering the cap rate. Of course there are many risk factors to evaluate in a property, but cap rate can give you a broad, albeit, simple overview.
Cap Rate and Realizing Opportunity Cost
It is wise, when finding a cap rate on a property you already own, to use the current price of the property to asses the cap rate, not the initial investment. The reason is it paints a more accurate picture of how your money is being used. For example, if I bought a property for $200,000, and it rents for $12,000/year, then the cap rate is 6%. But if the property appreciates to $400,000 5 years later, and rents increase to $18,000/year, I might be tempted to base the current cap rate on my initial investment since rents went up. The cap rate would then be 9%! Sweet! But, I would be forgetting the opportunity cost of having all my money tied up in that investment- $200K additional dollars now tied up in the property due to the price going up over time. Thats $200K "dead" dollars- money that is not working for me. If I look at the cap rate adjusted for current value it comes out to a 4% cap rate, not nearly as high as the 9% I thought I was getting. This could be a sign that I need to extract that $200K, or part of it, and put it to work in other investment vehicles or more real estate. Ideally as the property's price goes up over time, you want the NOI it generates to also increase over time, to maintain the cap rate at an acceptable level.
