Investments

What Does Cap Rate Stand For

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

The opportunity to make passive, periodic income is a major draw for real estate investments. That’s a big reason why I’ve been interested in buying a rental property. Simply said, if you can generate sufficient passive income to meet your living expenditures, you can retire early.

Additionally, cap rates short for capitalization rates allow investors to evaluate various real estate markets, evaluate the profitability of various assets, and more. Even after two or three helpings, you can complete the calculations on the back of a cocktail napkin.

How Do Cap Rates Work?

While the term “cap rate” may sound complicated, it is actually quite straightforward. They are a shorthand for the annual cash flow return on investment (ROI) you might anticipate from an investment property. 

Capitalization rates are used to compare income yields and do not take into account appreciation returns or financing costs. Thus, they provide a convenient shortcut for comparing the cash flow of various properties that can be purchased with cash.

Calculating capitalization rates

Calculating cap rates don’t necessarily require advanced math training. For capitalization rate, use the following formula:

Annual Net Operating Income (NOI) x Purchase Price = Cap Rate (or Value)

Take the scenario where a home costs $100,000 to buy but generates $8,000 in annual revenue. It results in an 8% cap rate. Just keep in mind that this is just an abridged version of return on investment; do not confuse it with your true cash-on-cash return; more on that later.

While it’s simple to grasp the purchase price, it’s more complicated to understand the annual net operating income, which has its own calculation.

Net Operating Income Calculation

NOI refers to the annual profit made by a property after all operating costs have been deducted. It’s easy for inexperienced investors and those who aren’t landlords to try to disregard or forget about operating expenses. 

However, expenses associated with rental homes typically amount to roughly 50% of annual rent. The 50% rule is a well-known concept in the world of real estate investing.

Other than the mortgage payment, these costs consist of:

  • Vacancy rate
  • Property management costs
  • Repairs and maintenance
  • Property taxes
  • Insurance
  • Accounting, bookkeeping, travel, legal costs, and other miscellaneous costs

As such, if the monthly rent on your first rental property is $2,000, plan on spending about $1,000 of that amount on things other than the mortgage. Such costs won’t crop up every month, but they’ll add up over time.

Oh, and a word to the wise include property management costs even if you intend to handle management in-house rather than hire a professional service. 

Whether you choose to handle the work yourself or hire a property management company, the cost of labor will remain the same. There will come a time when you can’t or don’t want to deal with tenants calling at 3 a.m. because a light bulb went out.

How to Predict Costs

However, the accuracy of your calculated cap rate will depend on the actual costs you incur. Check the accuracy of each of the aforementioned cost estimates. 

To learn the vacancy rate in a specific area, contact local landlords, property managers, and real estate brokers. The purchase price should be multiplied by the local property tax rate. Obtain insurance prices for your home, car, and other valuables.

What this means is that you should avoid making assumptions and instead use hard data whenever possible.

I normally budget about thirteen percent of the rent for upkeep and repairs. However, they usually amount to between 10 and 15 percent of monthly rent, on average, depending on the age and condition of the house.

What Are Cap Rates Used For By Real Estate Investors?

As a real estate investor, you can use cap rates in a variety of ways. Although there are more applications for this statistic, the following three should be kept in mind as you investigate single-family and multi-family real estate investments.

1. In order to compare properties

Take, for example, a pair of neighboring homes that are carbon copies of each other. Both are suitable for the same standard of the renter and are in identical condition. Which one is the better buy?

If you’re looking for a theoretically optimal purchase, the one with the higher cap rate is the one to go for. Values of rental income returns on investment properties can be compared quickly and easily using capitalization rates. 

They provide a convenient shorthand for a property’s income yield, making it easier to make comparisons between similar investments. Although the aforementioned case is unusual, a more typical scenario is as follows. 

You’ve done some research and have found a few places that seem interesting. You can get a cap rate of 8% with one of them, and 10% with the other. The higher-yielding property is located in a less desirable part of town, one with increased crime and tenant turnover.

Which one you choose to invest in depends on how comfortable you are with taking on the responsibilities of a landlord. It makes sense to choose the lower cap rate property if you’re concerned about things like security, tenant turnover, and tenant dissatisfaction. If you know the cap rates for both properties, you can weigh the benefits of the greater return against the dangers.

Roofstock is a marketplace for purchasing turnkey properties, and it allows you to narrow down your search based on the capitalization rate of available properties around the United States. Which can aid in the discovery of not only desirable homes but desirable real estate markets as well.

2. To Locate Profitable Markets

Cap rates are most useful, in my opinion, for helping real estate investors zero in on promising markets with high potential returns.

Even though renters and housing advocates in San Francisco have a penchant for griping about sky-high costs, the city’s rent-to-home-value ratio is really quite favorable to tenants. So much so that if they finance a normal rental property there, investors will see a negative cash flow.

There is a far higher return on investment for landlords in Memphis. As a result, cap rates are high because landlords benefit from the way rentals compare to the value of a dwelling. Compared to San Francisco, Memphis’s typical property price is a quarter of what it would be in the Bay Area, making the city an attractive investment option.

To locate markets with high rents in comparison to asset values, one can look into cities with higher cap rates. The result is a list of the top real estate investment cities in the country.

3. Setting an Offer Price Limit

Many property investors have a floor on the minimal cap rate they’ll accept for a given investment. In turn, this allows them to determine the maximum price at which they are willing to purchase a home.

Assume, for the sake of argument, that a multi-family dwelling can bring in $18,000 a year in profits. At the asking price of $300,000. that works out to a cap rate of 6% ($18,000 multiplied by $300,000.

However, as you require a rate of return of at least 7% ($18,000 $257,000 = 7%), you submit a best and final offer of $257,000. Whether the seller accepts or rejects your offer, you may rest assured that you are acting within the parameters of your investing strategy.

It allows you to set your own minimum standards for returns without worrying about what others think the property is worth.

The cap rate’s limitations

Cap rates are useful for quick comparisons of properties and for determining where to put money, but they also have some significant drawbacks.

First, their simplicity and ability to fairly compare qualities reduce their utility for you. You can make fair property comparisons if you don’t consider the cost of financing, but that won’t tell you how much return you can anticipate on your initial cash investment.

The cash-on-cash return measures how much profit you made in relation to the amount of cash you put into the transaction. That sum accounts for the initial purchase price, the cost of the mortgage, the cost of the closing, and the cost of making any necessary repairs and carrying the property until it is rented.

Assuming a mortgage will boost your cash-on-cash return is a mistake, too. When combined with debt, a below-average cap rate can result in a negative cash flow every month.

Let’s pretend there’s a property available for a 7% cap rate, provided you’re willing to pay cash. A $100,000 purchase price yields annual profits of $7,000. Let’s say you put down $20,000 on an $80,000 house and, after paying off your mortgage each year, you’re making a net profit of $2,600. 

You would be making a return of 13% if you did that ignoring closing costs in both cases, for the sake of a simple example.

Cash-on-cash return is the real bottom line for any given property, but cap rates can help you make a rapid analysis. Do the math to see how much money you’ll make per year after investing whatever you have.

Last but not least, keep in mind that there might be significant variations in the availability of financing and the terms on which it is offered from one region to another.

A lender in one state may offer you a loan at 4.5 percent interest, whereas a lender in another state with stricter laws and fewer lenders may charge you 6 percent. A lower loan-to-value ratio, such as 30% down instead of 20%, may be offered by lenders in states with stricter regulation. 

Loan fees, state transfer taxes, and recording costs may all be higher in certain states. Cap rates exclude financing conditions and closing expenses, yet these elements still have an effect on your profits and returns.

Why Is a “Good” Cap Rate Important?

In terms of what constitutes an acceptable capitalization rate, different investors will give you different answers. Although real estate investment trusts (REITs) are considered passive investments, real estate that is rented out requires significantly more time and effort on your part, so you should expect higher returns.

My personal threshold for investing in a property is a cap rate of 7% to 8%, and anything below that isn’t going to get me very thrilled. 

With real estates crowdfunding sites like Fundrise, Streitwise, and GroundFloor, I can make higher returns without having to deal with rent defaults, eviction moratoriums, or phone calls from adults who don’t know how to change a light bulb.

I was able to diversify my portfolio into commercial properties and real estate assets all around the country with the help of these platforms, and the minimum investment was much cheaper than I had expected.

The ease with which investors can now purchase real estate properties from anywhere thanks to sites like Roofstock has led to a swarm of purchasers in what was once a niche market, driving up prices and reducing returns. 

I find the typical return on investment for U.S. real estate to be unattractive, therefore in the current market, only truly extraordinary opportunities even get my attention.

A good cap rate would be. A real estate investment that outperforms the market by a large enough margin to warrant the hassles of managing a rental property.

Bottom Line

Cap rates simplify the process of contrasting the profits that various investment properties may generate. Consider them a foundational concept that any beginner investor in property should grasp.

However, they lack complexity and should only be used as a high-level appraisal method, not as the foundation for your investment selections. You can use them as a floor for setting prices, a ceiling for finding promising markets, or both. 

But keep in mind that their value is proportional to the precision of the figures used in the cap rate computation. Negligible vacancy or maintenance expenditures can have a significant impact on your cap rate and bottom line.

Dislike the concept of conducting so much study before purchasing property? You can avoid the time and effort required to learn the rental property market by investing in real estate through a crowdfunding site.

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