Capitalization rates (cap rates for short) are one way to talk about estimated investment returns in real estate. You’ll hear them mentioned a lot, such as “the cap rate is too low for this market”.
What is a Cap Rate?
The cap rate indicates the rough return on investment for a specific property at a specific point in time.
Net operating income (NOI for short) = how much a property makes after all expenses are paid except the mortgage (if applicable).
Market Value = how much the asset would sell for.
NOI/Market Value = Cap rate
Be careful – the NOI is calculated in different ways incorporating different expenses for different properties. Market Value is what someone (including you) is willing to pay for it and will be different depending on different buyers’ situations (such as who can get better loan terms or have access to economies of scale to reduce costs after closing).
Ask which ones are included, walk through the assumptions or do your own due diligence. You absolutely have the right to access the underwriting, expense and income information for a property before investing. Keep in mind numbers can be adjusted a lot to support the point of whoever is running the calculations. The banks all get this, as an investor it is important you do too. If someone won’t share the data with you so you can check it, that’s a red flag.
What do I use a Cap Rate for?
There are a few general trends for cap rates:
- Properties perform better when they are bought at a high cap rate and sold at a low cap rate. This typically involves adding value to the property and/or changing market conditions.
- Properties with lower risk tend to have lower cap rates than properties with higher risk.
The most useful thing is to compare properties in the same market.
Say a broker is offering a property at a 5 cap (that’s shorthand for a 5% capitalization rate). If other properties in the area are selling at a 6 or 6.5 cap, that’s a flag that either this property is much lower risk than the others OR the market value is higher than it can bear OR expenses have been creatively book kept to be very low. Or a combination. No matter which, it’s a flag to go dive deeper into the property finances.
For investors, cap rates can also raise a flag that underwriting may not be conservative. If the cap rate at purchase is the same or greater than the assumed cap rate at sale, the underwriting is not conservative. Banks generally assume an increase of 0.15/yr, so on a 5 yr hold 0.15*5 = 0.75 increase in cap rate.
Fun fact: the cap rate assumed at sale of a property is called the reversion Cap rate
Cliff Notes Questions for Investors
If you’re looking at a deal, here are a few Cap rate questions to ask the people who are underwriting it:
- What is the current cap rate and reversion cap rate?
- What are the cap rates for 3-4 similar properties in the same market?
- How have the expenses used to calculate NOI changed over the past 3 years?
- Will you walk me through your underwriting (or send me a link to it)?
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