Understanding Cap Rates: What Every Real Estate Investor Needs to Know

Understanding Cap RatesHomeUnion’s hands-free real estate investment service opens the doors for you to invest in a variety of cities and neighborhoods far from your hometown that you may not know very well.  As an investor, this is great news – you get access to investment properties you ordinarily wouldn’t have.  This does leave you with a conundrum: how can you compare the opportunities and find a house in an unfamiliar market that promises the best return for your investment?

It doesn’t help that every property is different.  One house might be easier to rent than the one next door.  Every real estate market is also different due differing economic conditions, demographic factors and geography.  Knowing what kind of a return to expect for a particularly property over a long period, say ten years, is difficult to forecast with much precision, though it may not be as difficult as forecasting the return on investment that you would receive by investing in the stock market with a stock index fund.

To estimate and compare the profitability of investment properties, whether they are single family homes or luxury highrise condos, real estate investors developed a simple formula to estimate profitability.  These  “cap rates,” or capacity rates, measure the capability of a property to recoup the initial investment and deliver profits going forward.

Calculating Cap Rates

Before you buy a property, it’s a good idea to estimate the cap rate to get an idea of its potential rate of return.  To figure the cap rate for a particular property, you begin by calculating the net annual income.  If you don’t own the property it is going to be difficult to know the rental income and costs involved in maintaining and managing it.  To research local rental rates, find ads for similar properties or apartments in the same zip code.  Subtract 10 percent of your total annual rental income to account for a potential vacancy.

To determine net income you will need to subtract all costs involved in operating the rental: management costs, taxes, utilities, insurance and any other expenses such as maintenance.

Next, divide your net operating income by the total acquisition cost for the property, including brokerage fee, closing costs, and all the rehab costs necessary to make it “rent ready.”  The result will be your cap rate, expressed as a percentage.  Your cap rate is the equivalent of the net operating income (NOI) for your investment.  It is an estimate of your cash flow income and, if you made your acquisition in cash, it is your return on investment (ROI).

The simple cap rate formula assumes that acquisitions are all cash and do not involve finance charges.  If you are financing a purchase, you need to include the annual costs of financing your property as an operating expense.

Immediately you can see the relationships between rents, operating costs and acquisition costs.  If the cost of acquiring your property is higher than comparable rentals in your market, you are going to have to charge more rent to achieve the same cap rate.  If you can’t rent the property at a higher rate to account for the higher acquisition cost, your cap rate is going to shrink.  On the other hand, if you can acquire and renovate a property for less than comparable rentals and rent it out at the going rate, your cap rate will rise and your rate of return will rise.  You can see why foreclosures and short sales are such a boon to “buy and hold” investors as well as flippers.

Calculating cap rates makes you aware of the importance of controlling operating costs.  Operating costs are subtracted from your rental income to give your net income.  Every unnecessary operating cost has the effect of lowering your rental income.  When you can achieve operating costs lower than your estimate, your cap rate and profits rise.

When comparing cap rates, be sure to check that all costs are included and that you are comparing “apples to apples.”  For example, some rates leave out a consideration for vacancies, while others do not.   It’s also important to avoid comparing apartment cap rates with single family rentals.  Though rent rates and cap rates for the two forms of residential rentals are sometimes lumped together, they are very different products with different costs and rent rates.  Finally, remember that cap rates are always expressed as if acquisitions were all cash.  For properties that are financed, leave out finance charges when comparing with other properties.

What constitutes a “good” cap rate depends on your investment goals.  Most investors would consider an ideal cap rate that includes all operating and acquisition costs to be 10 percent or better, though many do well as low as seven percent.

Cap Rates by Market

Just as cap rates differ by property, they also differ by market.  Operating costs, acquisition costs, and rents all vary significantly.  These factors are constantly changing with real estate inventories including foreclosures and short sales, local economic trends, rental demand and supply, taxes and rent rates.

Several real estate data firms provide current market-by-market information on cap rates that is available by subscription.  RealtyTrac and Local Market Monitor are available for residential real estate.  Reis Reports and CBRE provide information on the commercial sector. Keep in mind these are just a beginning point to research a market.  The data consists of market-wide averages based on average rents and costs.  Cap rates within a market will vary widely based upon local neighborhood conditions as well as your ability to find a good deal.

Below is a graph charting changing cap rates in Detroit from Local Market Monitor.  In partnership with HomeVestors, Local Market Monitor also issues a quarterly ranking of markets for investors.

Detroit Cap Rates

Detroit cap rates, 2000-2014

Here is an April 2013 ranking of best markets to by a rental property from RealtyTrac that lists 20 rental markets by several key metrics including cash cap rates.  These and other services issue occasional rankings of markets for investors.

SFR Cap Rates

Cap rates can be a useful management tool and a helpful way to shop for markets and individual properties.  When making a decision about buying a property, however, they are not the final word.  For one thing, they do not take into account appreciation, which will be an important factor in the return on your investment.  The cap rate formula also does not take into account real world opportunities and risks.  For example, if you know a market is poised to grow it might be worth investing now and toughing it out with moderate results for a couple of years in return for higher rents as the local economy improves.

Whether you choose to work with a firm like HomeUnion, or venture out on your own, this is just one metric that you should use to vet out your potential rental properties.


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Property Assessment Values | Mashvisor Sep 24 2016 - 8:52 AM
[…] agent feesm, etc. You can use an investment property calculator to simplify this process. A “good” cap rate depends on the area and property you are looking […]

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