When evaluating potential income producing real estate investments, you should consider a property’s capitalization rate, also known as the “cap rate.”
What is a cap rate? It is a figure representing an investment’s rate of return. A property’s cap rate also gives you an idea about how risky the investment is. Finally, the cap rate helps you approximate how long it will take to recoup the investment dollars spent to acquire the property.
How is the cap rate calculated? Here is the formula:
Net Operating Income (NOI) / Current Market Value (CMV) = Capitalization Rate
Let’s take a look at Current Market Value and Net Operating Income before we run through our cap rate examples.
Current Market Value
The Current Market Value is the price that a buyer is willing to pay for the property in an arm’s length transaction in the marketplace today, i.e., a good faith buyer unaffiliated with the seller. The Current Market Value is what the property is actually worth right now. You should include in the Current Market Value figure the cost of any upfront (within the first year after purchase) repairs or improvements you plan to make to the property.
Net Operating Income
When determining a property’s Net Operating Income, the first thing you want to do is calculate the property’s annual gross rental income. For example, if a quadplex you are thinking about purchasing is collecting $1,100.00 per month from each of the property’s four tenants, then the annual gross rental income for that property will be $52,800.00 ($1,100.00 x 4 tenants x 12 months).
The next step in determining a property’s Net Operating Income is to deduct the property’s annual operating expenses from the annual gross rental income. Operating expenses deducted from the gross rents include property taxes, insurance, maintenance and repair expenses, utilities paid by the landlord, and other operating expenses. However, operating expenses do not include debt service, so mortgage payments are disregarded.
If the quadplex you are researching has annual operating expenses of $8,500.00, then its Net Operating Income will be $44,300.00 ($52,800.00 annual gross rental income – $8,500.00 annual operating expenses).
Let’s take a look at two cap rate examples.
Cap Rate Examples
George can buy a multi-family property on Johnson Street for $350,000.00. The monthly gross rental income generated from the property is $4,400.00. The monthly operating expenses for the property are $1,500.00. Therefore, the monthly net operating income is $2,900.00 ($4,400.00 monthly gross rental income – $1,500.00 monthly operating expenses). To come up with the annual figure we simply multiply the monthly figure by 12, which equals $34,800.00 ($2,900.00 monthly net operating income x 12 months).
Here is what the cap rate will look like for the Johnson Street property:
$34,800.00 (NOI) / $350,000.00 (CMV) = 9.94% Cap Rate
George locates a second multi-family property on Tucker Avenue that he can buy for $275,000.00. The monthly gross rental income generated from the property is $4,800.00. The monthly operating expenses for the property are $850.00. Therefore, the monthly net operating income is $3,950.00 ($4,800.00 monthly gross rental income – $850.00 monthly operating expenses). To come up with the annual figure we simply multiply the monthly figure by 12, which equals $47,400.00 ($3,950.00 monthly net operating income x 12 months).
Here is what the cap rate will look like for the Tucker Avenue property:
$47,400.00 (NOI) / $325,000.00 (CMV) = 14.58% Cap Rate
Reviewing the Data
We have the cap rates, so now what? The data tells us a few things.
First, the Tucker Avenue property (14.58% cap rate) has a significantly higher return on investment than the Johnson Street property (9.94% cap rate).
Second, it will take George 10.06 years (100% / 9.94%) to recoup his initial investment on the Johnson Street property; and it will take George 6.86 years (100% / 14.58%) to recoup his initial investment on the Tucker Avenue property.
Lastly, the Tucker Avenue property appears to be a much higher risk investment than the Johnson Street property. We know that an investment’s rate of return is based on risk. A higher rate of return means more risk. A lower rate of return means less risk.
Why is Tucker Avenue such a higher risk investment than Johnson Street? That is something that the numbers cannot tell us. For some reason, the property on Tucker Avenue can be purchased for $75,000.00 less than the Johnson Street property and has much lower operating expenses, but it is producing higher rental income than the Johnson Street property. At a minimum, the difference in cap rates between two comparable properties should raise some red flags say you need to investigate further.
As you can see, cap rates can be very useful in evaluating potential income producing real estate investments. Cap rates can help you compare investment properties located in different cities, different neighborhoods, and even comparable properties within the same neighborhood to estimate your return on investment, your investment risk and how long it will take to recoup your original investment.
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