The Real Estate Investor’s Guide to Understanding Cap Rate

For real estate investors, understanding and calculating capitalization rates (cap rates) is a key metric for forecasting return on investment (ROI). But, for those new to real estate investing, the concept of cap rate can be a bit confusing. Understanding and calculating cap rate can help investors know if their real estate investments are a potential dud or a home run. Let’s break it down.

What is a Capitalization Rate?

A capitalization rate (cap rate) is a ratio between the net operating income (NOI) of a property and the original capital cost or its current value. It tells investors what percentage of their property’s value is profit. This is important information when forecasting ROI or determining if operating costs are making investments unprofitable.

How to Calculate Cap Rate

Calculating a traditional cap rate is a fairly straightforward process. Here are the steps:

Step 1: Determine the asset value. You can use online real estate classified sites, or Stessa’s valuation tool. Normally, Stessa uses Zillow’s Zestimate to establish the current valuation for your investment property.
Step 2: Determine the net annual operating income (NOI). This includes all income, such as rent, parking, in-unit laundry if you have it, and more.
Step 3: Subtract operating expenses. Deduct all costs—excluding the mortgage—such as property management, owner association dues, taxes, insurance, and so forth.
Step 4: Divide your net income by your asset value.

Using this simple formula, investors can find properties with the best cap rates, and therefore, the best ROI.

Real estate investing is an incredible way to secure financial future and independence. But, with any investment, understanding and calculating the cap rate is a critical step to ensure you make the right decision. With this formula, you can make sure your investments are home runs and not duds.

Using Cap Rates to Assess Risk in Real Estate Investing

Before you start crunching numbers and planning your real estate empire, let’s be clear: cap rates are directly correlated to risk. Generally, the higher the cap rate, the riskier the investment. In other words, a high cap rate usually indicates that the asset price is low, which usually points to a riskier investment. However, you must compare to market cap rates in your area, as they can vary significantly.

So, proceed with caution. A property with a high cap rate might not be the best investment for you if you’re not in a position to tolerate excessive risk.

Factors That Impact Cap Rate

Now that we understand what a cap rate indicates, let’s get into the factors that affect this score and what they mean for real estate investors. You’ve heard it a million times: location is everything in real estate. Location has a major effect on a property’s cap rate. For example, a property located in a hot, in-demand downtown area will have a very different cap rate than one in a rural town.

That doesn’t mean that a property in Manhattan will always have a higher cap rate than one in Des Moines. Markets with higher demand will have higher priced properties and higher potential operating income. But if the market begins to show signs of cooling and rents drop, so will your cap rate.

On the other hand, chronically low cap rates will show little signs of improvement over the long-term. Generally, the most reliable cap rates favor urban areas, as well as more highly educated populations and a diversified economic base.

So, a property with a lower than average cap rate may not be the best investment either. Don’t just hope for higher demand. As a real estate investor, you must have local knowledge about the fundamentals of your area. A low cap rate may be worth considering if you know that a factory is moving into town or a major public transportation project is being built nearby.

Understanding Cap Rate: The Vital Metric for Investors

For investors looking to build wealth, mastering the cap rate metric is a must. But what exactly is a good cap rate?

Some aggressive investors won’t touch a property with a cap rate of less than 8%, while others might even insist on double digits. However, for those looking for a respectable ROI without excessive risk, experts agree that a cap rate between 4% and 5% is optimal. This range yields plenty of potential properties and is stable enough to maintain a steady stream of revenue without undue risk – of course, this depends on the fundamentals of the real estate markets you operate in.

Automate and Optimize

Investors want to understand whether or not their properties are performing beyond just the cap rate. To do this, it’s important to automate as much as possible and make the most of our most valuable asset: time.

Stessa’s automated income and expense tracking, for instance, will auto-categorize your expenses to help you quickly calculate NOI, which allows you to much more accurately calculate cap rates in your market.

Other Factors To Consider

While cap rate is an important metric to consider, it shouldn’t be the only green light. Every investor’s circumstances are different, so it’s important to look at other factors such as cash flow before making an investment decision. What might be a profitable asset for one investor might end up being a liability for you.

At the end of the day, cap rate is a vital metric for any investor looking to build wealth. However, it’s important to evaluate your investment holistically, considering all factors before making a decision.

A guide by Chiles Capital, LLC