The 2020 real estate investor’s guide to understanding cap rates

cap rates for real estate investing
by Brad Cartier, posted in Finances, Guides, Investment Strategy

For real estate investments, cap rates are calculated by dividing your net operating income (NOI)—rent minus expense—by the market value of a property. Your expenses include everything except mortgage payments.

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Over the past decade, real estate has bounced back and presents perhaps the single best way for entrepreneurs to secure their financial future. After all, Marshall Field once said, “Buying real estate is not only the best way, the safest way, the quickest way, but the only way to become wealthy.” While that’s straightforward enough, there are obviously a number of pitfalls along the way that can turn your dreams of financial security and independence into a nightmare of bad debt, poor returns, and lost opportunities.

So, how do you know if your real estate investment is a potential dud or a home run? It’s simple: cap rates.

If you’re new to real estate investing, a cap rate—short for capitalization rate—is a primary metric we use to forecast the ROI from our property. This number is calculated as the ratio between the net operating income produced by your property and the original capital cost or its current value.

Cap rate also helps us determine what percentage of our property’s value is profit. This is vital information for us real estate investors, as it helps us to determine if we are actually achieving our ROI forecasts and whether or not operating costs are making our investment unprofitable.

If you’re scratching your head, don’t worry. There’s a simple formula for figuring out a traditional cap rate.

Calculate cap rate

Step 1: Determine your 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. But, because this valuation is more accurate for single-family homes rather than multi-family assets, you can change the valuation methodology to gross rent multiplier, or by using cap rates.

For our purposes, you can set the valuation based on an estimated cap rate applied to projected (actual or market) NOI with a vacancy assumption.

Either way, you must establish the current market value of the property. Or, contact your broker or appraiser to get an idea of the current market rates and the value of your property. For this exercise, let’s say it’s a duplex in Texas valued at $300,000.

Step 2: Determine net annual operating income (NOI). This includes all income, such as rent, parking, in-unit laundry if you have it, and more. The NOI provides the clearest picture of the day-to-day performance of a rental property.

Using your market value research, check similar units in the area and determine how much income you will generate in annual rent. Or, use your current numbers if it’s a property you already own.

For our duplex example, let’s say you make $1,200 in monthly rent from each side, so $2,400 a month total, and $28,800 annually.

Step 3: Subtract operating expenses. Deduct all costs—excluding the mortgage—such as property management, owner association dues, taxes, insurance, and so forth. Let’s say you self-manage, and your total operating expenses are $1000 monthly. That leaves us with a net income of $16,800.

Step 4: Now, divide your net income by your asset value – that’s $300,000 by $16,800 in our case. That gives us a cap rate of .056 or, 5.6%. Not too shabby! It might be a little risky, and we’ll see why in just a minute.

We can use this simple formula to find properties with the best cap rates, which in turn, give us the best ROI.

How to use cap rates

Now before you go crunching numbers and planning your real estate empire, let’s be clear: cap rates are correlated to risk.

Overall, the higher the cap rate, the riskier the investment. That is, a high cap rate means your asset price is low, which typically points to a riskier investment. But 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.

Now that we’re clear on what a cap rate indicates, let’s dig a little deeper into the factors that impact this score and what they mean to a real estate investor.

I know you’ve read it a thousand times, but here it goes again: location is everything in real estate. And location has a profound effect on a property’s cap rate. For instance, a property nestled in a hot and in-demand downtown location will have a very different cap rate than in a sleepy town somewhere in the rural Midwest.

But that doesn’t mean that a typical property in Manhattan will necessarily have a higher cap rate than in Des Moines. Markets with higher demand will have higher priced properties and higher potential operating income. But once a market shows signs of cooling and rents take a dip, so will your cap rate.

On the other hand, chronically low cap rates will show little signs of improvement over the long-term. Typically, the most robust and 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 probably isn’t a wise investment, either. Don’t cross your fingers and hope for greater demand.

As a real estate investor you must have that local knowledge of the underlying fundamentals of your area. A low cap rate may be worthwhile if you know there’s a factory moving into town, or a major public transportation development going in next door.

What’s a good cap rate?

Some aggressive investors won’t touch a property with a cap rate of less than 8%. And some yet will even insist on double digits. Again, there are a lot of varying factors at play, so a cap rate of around 6% might be considered fantastic in certain markets.

For investors like us – people who might not be able to tolerate excessive risk yet still want to see a respectable ROI on our property – a cap rate between 4% and 5% is optimal according to experts. This range yields plenty of potential properties and is stable enough to maintain a steady stream of revenue without assuming undue risk. Again, this totally depends on the fundamentals of the real estate markets you operate in.

Create processes and automate

So the question then becomes—how do I know if my property is performing other than just a cap rate? Obviously, there are a number of different ways to gather a global view of your investment performance, but as sophisticated investors, we must automate as much as possible.

Cash is not the most important currency—Time is.

Time is our most important asset, so it’s important you bring in automation and systems where possible to generate the reports you need to understand whether or not your properties are performing. 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.

Conclusion

Every investor’s circumstances are different, so a good cap rate shouldn’t be your only green light. There are many, many other factors to consider before you make an investment decision. For instance, your cash flow picture might look very different to another investor’s on the same property. A profitable asset for one investor might end up being a liability for you.

But, regardless of your specific financial position, a property’s cap rate will remain the same from investor to investor, helping you consistently and accurately benchmark profit potential. That’s why cap rate is a vital metric to master if you’re serious about building wealth.