A regular question asked by investors regarding a property is “what about the cap rate?” Capitalization (cap) rates are an interesting financial measurement that provide a measure of return for a property and its valuation.
While some residential investors spend time wondering about the cap rate of an investment, it is probably not the best measure to consider. Nor is it possibly even informative for a residential investment.
What Is A Cap Rate?
Cap rates measure the operating income of a property against the value of the property. It is the rate of return expected to be generated on a real estate investment. This rate of return is the yield of the property, for a one-year period, assuming a cash investment.
Keeping this simple:
Capitalization Rate = Net Operating Income/ Current Market Value
Net Operating Income = Expected annual income generated by the property less all expenses incurred for the property. These expenses include taxes, maintenance, and management fees. Note: interest carry is not an expense that is applied to operating income.
What Is The Value Of A Cap Rate In Investments?
Investors discuss a cap rate for a property and people nod their heads in agreement or even awe. But, really… what exactly does that percentage mean?
What is the value of a single percentage measurement? Cap rates have value when comparing multiple investment choices. Then an investor, can assess where the best investment lies.
Cap rates also assist in selling an investment. Applying a “market” cap rate to a known net operating income will provide a valuation that can be used in selling a property. So, for example, two similar real estate investments. One is in the urban, trendy area and the other is in a rural town. The urban property will have higher income but higher expenses. It also will likely have a higher valuation so a lower cap rate.
Remember, a lower cap rate leads to a better valuation. The higher valuation also reflects possible better returns with a lower level of risk. On the other hand, a higher cap rate implies lower valuation which leads to less return and a higher level of risk.
Why They Are Not Valuable For The Average Residential Investor
The average residential investor is using debt and the cap rate does not account for financing. Large institutional investors paying cash can compare several properties based on their cap rates and determine what is likely the best investment. They do not have the financing component to the investment. If there will be a loan used to purchase the property there will be an interest factor and return of principal. The true return is after debt service. Debt service may vary based on the investment. The capitalization rate does not account for the financing.
So, refer to cap rates with some caution. It is certainly wise to be able to calculate this measure. But, the real value in the cap rate is to compare like properties, or the potential return received, compared to other types of investments. While assuming all cash purchases.