Capitalization (or cap) rates are the most commonly used metric by which real estate investments are measured. Which begs the question – what is a good cap rate for an investment property? As with any complex topic, the answer is that it depends.
My simple answer is that a good cap rate is anything the gives you good positive cash flow. Afterall, here at the Old Dawg’s REI NETWORK, “cash flow is king!” It’s real just that simple!
However, as you begin to move beyond investing in single family homes into commercial multifamily properties or other commercial properties such as office buildings, triple-net retail, etc. , cap rates take on a much more significant role in the assessment and analysis of investment properties.
My focus here, will be residential multifamily properties with 5 or more units. These are considered commercial properties. And as such, banks and investors, as they assess the value of a commercial property, they look more at the “profitability” or “return on investment” of that property as opposed to “market comps” that are the primary assessment metric for single family and small multis.
A cap rate for an investment property is one of the most important tools in the world of real estate investing. And like other metrics (i.e. ROI, IRR and others), it can also be a complicated one with no single, straightforward answer.
To begin with, let’s define cap rate. As I mentioned before, capitalization rate is one of the most commonly used metrics to measure the profitability of a real estate investment. It describes the rate of return of a rental property regardless of the method of financing. In theory, cap rates are a measurement of the level of risk associated with an investment property. A lower cap rate corresponds to a lower level of risk, whereas a higher cap rate means a higher level of risk. This is logical as investing in low risk is associated with low profitability, while high risk is related to the possibility for bigger gains. Not sure I agree!!!
Another reason cap rate is important is that is a ratio that helps us determine the value of a multifamily property.
The formula is simple: you divide the net operating income (NOI) by the property price (or value).
Cap Rate = NOI/Price
Let’s look at NOI (or Net Operating Income): To calculate the NOI, you need to start with the annual rental income from an investment property and subtract from it all costs/expenses associated with operating the property, including taxes, insurance, management costs, utilities, maintenance, and others. The basic cap rate formula, as we show above, assumes that acquisitions are all paid for in cash and do not involve finance costs. If you, however, are financing your purchase (through a bank loan, let’s say), you will also need to include the annual cost of financing your property (your mortgage payments) as an operating expense.
Now let’s look at Price: The price is the price that you pay for the rental property in addition to all other acquisition costs such as brokerage fees, closing costs, rehab costs, etc.
For Example (now, note, all of the examples and calculations I’ll be giving are in our show notes at olddawgsreinetwork/blog – look for show number 148):
Let’s say it costs you a total of $170,000 to buy a rental property. You pay cash. You can rent it out for $1,500 per month. All annual costs related to your property add up to $3,000 (remember, you do not have a mortgage). To calculate the cap rate:
Cap Rate = NOI/Price
NOI = annual rental income – annual operating costs = 12 x $1,500 ($18,000 as your annual income) – the $3,000 (which are your total operating expenses) = gives you $15,000
Now, take your NOI of $15,000 and divide it by your price of $170,000, and you get 8.82% — that’s your CAP rate
Cap Rate = $15,000/$170,000 = 8.82%
Capitalization rates are also an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after 8.82 years (100% divided by the cap rate of 8.82%).
Now that we’ve gone over the calculations, let’s go back to our initial question: what’s a good cap rate for an investment property. Now, I will tell you, there is no unanimous answer to this question, where everyone will agree. However, most experts tend to agree that the value of a cap rate should be around 10%. For most rental properties around the U.S., the value is between 8% and 12%.
What is an acceptable cap rate for my property?
First, the cap rate varies based on the asset type. For instance, multifamily properties consistently have the lowest cap rate because they are considered to provide among the lowest risk. The reason is simple. Apartment buildings generate their rental income from numerous tenants every month. So, even if one or two of your tenants don’t pay their rent for a certain month, the change in your cash flow for that month is relatively small. Conversely, imagine a large, luxurious house that you rent out to a single family. If the tenants don’t pay their rent for this month, you’re left with no income. The risk is high.
Second, the cap rate is different in different markets. As you’ve heard many times, in real estate investing, location is everything. States, cities, and neighborhoods all have different cap rates. This is partially because rents, operating costs, and acquisition costs change from one place to another. They also change over time. Different markets also exhibit different supply and demand, which will also cause significant differences. So, while you can use cap rate to compare the risk and the profitability of comparable properties in the same market, you shouldn’t decide between buying a small apartment in Boston or a two-story house in Miami solely based on it. As a general rule, you need to indentify the average cap rate in the area that you are considering as your minimum goal when purchasing an investment property.
Now, this can be frustrating, too, as it is not always easy to identify what the local cap rate is. It may change from neighborhood to neighborhood. I recommend you ask a real estate commercial broker in the area and, even at that, expect the cate to vary from broker to broker. At best you will get a range.
In conclusion, the capitalization rate is a helpful metric to use when shopping for a market and for a property. However, you should not base your final decision regarding your property purchase entirely on cap rate. A major disadvantage of the cap rate is that it doesn’t take into consideration the depreciation/appreciation of a rental property, which plays a major role in determining the return-on-your-real-estate-investment. Also, it does not account for the way of financing your property. Importantly, the cap rates may be misleading in growing markets. For example, even if the cap rate is not great at the moment, it might be worth it if you invested in a property in a market that is set to grow. This gives you the opportunity to enjoy higher rents and a significant appreciation of your property in a few years.
What it is really all boils down to is this: If you buy at a price better than the market cap rate but you are bleeding cash each month, your business will fail. If you have cash left over at the end of the month, your business will succeed. It’s really as simple as that!
For more information on cap rates, check out podcast #024 entitled, “What is a cap rate why is it important?”
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