What is a Cap Rate?Dec 14, 2020
In this article:
- What is a Cap Rate?
- The Cap Rate Equation
- [Example] Calculating Cap Rate
- Common Mistakes
- What are My Operating Expenses?
- What is a Good Cap Rate?
What is a Cap Rate?
You've maybe heard it called "cap rate", or maybe just "cap". The capitalization rate is a mathematical measurement that represents how much income a property produces relative to its purchase price. In many ways a cap rate is similar to gross rent multiplier (GRM), but with a more precise look since as it considers operating expenses and vacancy as well.
If you're looking to compare two investment proformas in order to decide where to put your money—remember that cap rate is how much money the property generates relative to the price you pay.
So when we look at the cap rate on a property, we're going to be focusing on two factors. the property's income, and price. Specifically, it's Net Operating Income, or the gross rent that the property collects less it's vacancies and operating costs (see example calculation below).
The Cap Rate Equation:
Cap Rate = Net Operating Income / Purchase Price
Net Operating Income (NOI) = the sum of all potential income - vacancy & operating expenses.
An Example of Calculating Cap Rate: (via BiggerPockets)
A 10-unit apartment building is offered for sale at $1 million. Its annualized rent roll is $100,000 with operating expenses totaling $40,000. What’s the Cap Rate if the average vacancy rate in the area is 5%?
Capitalization Rate = ($100,000 – ($100,000 x 5%) – $40,000) / $1,000,000 = 5.5% Cap
Most inaccuracies in calculating cap rates stem back to mistakes made in determining net operating income. Make sure that you are doing your best to find actual numbers and not just estimates of what your operating expenses might be. Of course, if you're working with new build proformas, there won't be actual numbers. In this case, the cap rate is a calculated prediction of what future expenses/price will be. If expenses are misrepresented, NOI can become skewed, thus making the cap rate a poor estimate of value for the property. Below is a typical list of operating expenses to include/not include:
What are My Operating Expenses?
What it is:
- Property Management
- Real Estate Taxes
- Trash Removal
- Gas & Water
- Business Fees
What it Isn't:
- Capital Improvements
- Mortgage Payments
What is a Good Cap Rate?
What is typically labeled as a "good cap rate" can vary significantly as you look at properties across different markets. This is something you'll have to take into account when you're researching investment opportunities in different states.
For example, if you're living in Southern California and are used to looking at the average local cap rates, you'd be surprised at what you find in markets like Houston, Salt Lake City, or Boise. The short answer to "what is a good cap rate?" is that it depends. What is considered "good" for a specific market can vary based on what you're looking for and for the average in that area.
What we recommend: familiarize yourself with what the average is for your market. If you're looking to invest in fourplexes, for example, look at the going cap rates for projects similar to what you want to invest in. If your market shows an average of a 5-6% cap rate, then what you may consider a "good investment" might be something 1-2% higher. That is what we shoot for here at FIG. If we're looking to start a build in a new market, we'll research ways that we can create an investment that produces a 1-2%+ higher cap rate than the local average.
Remember, the cap rate average in one market could be 1-3% higher or lower than in another market you're looking at, that's why there's no such thing as one universal "good cap rate."
It just depends on what the market is telling you. Just like we did in our example video above, keep calculating the cap rate for different properties within your target market. Pretty soon you'll have a good grasp on what the going cap rate is for that area.
For example, for what we see for Arizona, Idaho, Utah, the average cap rate right now is about a 5% cap rate (maybe a little bit lower). That's what we see for investment properties that are currently trading that are finished and leased up. When you're investing with FIG, there's a little bit of risk that you take on... you take on the risk of a construction loan, and you have to wait through the build period. Those are some of the risks or downsides. However, the upside is that the cap rate tends to be 1-2% higher than the average for that market is.
In the proforma for our fourplex development in El Mirage, you see a 6.1% cap. We know that the market cap rate for investment projects that are finished is around 4.5-5%. That's what makes our projects look so attractive to investors (multifamily for sale).
Cap Rate Summary
What is Cap Rate? Cap Rate is an evaluation used in real estate to compare one investment property with another investment property. You can find this number by taking your yearly NOI (Net Operating Income) and dividing that by the purchase price.
Step one you need to figure out your income—what you're going to be bringing in and collecting, You want to know what you're going to be making on that investment. Step two, you'll be determining all of your expenses. Once you know those two things, then you can figure out what your NOI is going to be. Once you have your yearly NOI, divide that amount by the purchase price, and you get your cap rate!
So when you're looking at other investments, and you're comparing apples to apples—it seems like such a simple little number, but it's very important, if you want to truly understand and evaluate one investment versus another.
Something Not Making Sense?
If you've been looking at some of our proformas found on our Current Projects page and still have a question or two—we'd be happy to clarify things for you! Send an email t our team at [email protected] we'll respond as soon as possible!