CAPITALIZATION RATE EXPLAINED
The capitalization rate (or cap rate) is a formula used in real estate to calculate the presumed rate of return on an investment. The cap rate represents the return over a one-year time span and only applies when the property is bought with cash instead of financed. Because it measures value over time, the cap rate is more suitable for long term investments whose aim is to generate rental income rather than a quick fix-and-flip investment.
This is useful for investors to determine how much return on investment they can expect from a particular building and can be a very useful tool for determining which building to invest in when considering multiple buildings. Essentially, it is a useful indicator (although not the sole indicator) of whether a property is becoming more or less profitable.
CALCULATE THE CAP RATE
The cap rate formula is calculated as:
Cap rate = Net operating income (NOI) / current market value
The “net operating income” is the expected income you will get from the property over the course of a year. So, if you are renting a property for $1,000 a month, then your net operating income would be calculated as $1,000 x 12 months = $12,000 per year. This gives you your gross operating income, or your income before expenses. To calculate the net operating income, you then need to factor in any costs associated with the property, including insurance, taxes, property management fees, and estimated maintenance costs. Once you calculate net operating income, divide it by the property’s current market value to arrive at the cap rate.
As an example, let’s say you’re buying a million-dollar property, and predict that it will generate $70,000 per year in income after all of your expenses have been accounted for.
$70,000 / $1 million = 7% cap rate
So, say you have also been eyeing an alternative property in the same neighborhood that would bring you in a net operating income of $90,000 per year, but costs a bit more at $1.5 million. Dividing 90,000/1,500,000, you find that this property has a cap rate of 6%. In this example, it may be more profitable for you to invest in the million-dollar property, even though it is bringing in less income at face value.
It’s also important to note that market values tend to increase over time. This means that if your net operating income isn’t keeping pace, your cap rate percentage is going to fall. To maintain profitability over time you need to ensure that you are growing your income at a rate that is greater than or equal to the rate at which your current market value is growing.
ASSESSING YOUR RISKS
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, changes to the value of money over time, future cash flows from property improvements, and a range of other considerations. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
Just remember, a cap rate isn’t the only indicator of a good or bad investment. Let’s say you buy a piece of property for $1 million, expecting to make $100,000 per year from renting it. This would give you a cap rate of 10%. That sounds great, but if the local housing market changes and the value of the property increases to $1.5 million, you would be left with a cap rate of 6.6%, which is significantly lower.
In a situation like this, selling the property and collecting the immediate profits might be a better idea than renting it out in hopes of an ongoing profit.
DEMAND, INVENTORY, AND TYPE OF PROPERTY
It is important to note that supply and demand also affect the cap rate. While the property you are looking at might have an attractive cap rate, you could be overestimating the amount of net income you will be able to draw from it if it is in a high demand area. If there is an abundance of similar properties in the area, those are going to impact both your current value and the amount of income you generate. If other landlords in the area try to stay competitive with each other by continually dropping their rents, you could end up with either an empty property or be forced to rent out your property at a lower rate than you initially calculated.
Similarly, the type of property you invest in is also going to affect the cap rate. For example, commercial properties likely require a much larger cap rate, because they carry a higher level of risk with them. As we have seen with the COVID-19 pandemic, economic downturns and other catastrophes can drastically reduce the demand for office or retail space and could leave you sitting with an empty building that nobody is looking to rent. Residential properties are considered safer because people are always going to need a place to live. So even though residential property has a slightly lower cap rate than commercial property, residential property is usually a sounder investment.
FACTORS OF INFLUENCE
In addition to supply and demand, there are some other factors that could also impact your cap rate.
The first of these is the location. It is no secret that location is the biggest single driving factor in real estate. Before you decide to buy a property because the cap rate tells you it’s a great deal, you should evaluate where it is located.
You also need to consider what kind of rental you are purchasing. If you’re purchasing the property as a high dollar vacation rental, then your average rent will be much higher. But, it might also come with higher maintenance costs and could introduce higher levels of uncertainty to your annual net operating income estimate as rentals increase or decrease with the on- or off-seasons.
WORK WITH THE KATIE ZARPAS GROUP
Reach out to the real estate professionals at the Katie Zarpas Group in Virginia Beach for more information on investment properties.
Before entering the luxury real estate industry in 2005, Katie Zarpas worked as an assistant film director and thus acquired many valuable connections in the entertainment business.
Katie has since earned several accolades, including the Hampton Roads Realtors Association’s prestigious Gold, Platinum, and Diamond awards. She has also been ranked as one of the top realtors in the country.
At the Katie Zarpas Group, we help clients obtain key information about listings in Virginia Beach and the surrounding areas, including Norfolk, Chesapeake, Portsmouth, and Suffolk. We strive to constantly track local real estate market trends, which means we can help you estimate your desired home’s value and investment potential.
We will always put your priorities first, regardless of what you are seeking. Call the Katie Zarpas Group today at (757) 685-4400 or contact us online to learn more about our work and how we can assist you.