xhv8mzw7ge79waga35o97s2wbzpfr6 Getting a Grip on Cap Rate [Investment Math]

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FIG DISCLAIMER: No investments are guaranteed to result in profits. Net operating income, cap rates, and internal rates of return are subject to fluctuation and may experience a wide range of change, including the potential for operating losses. Factors affecting investment returns include, without limitation, changes in interest rates, tenant vacancies and defaults, property management expenses, repair and maintenance costs, HOA expenses, litigation, insurance rates, and relative strength and weakness in the local and regional economy. Past performance is not a guarantee of future returns. FIG does not provide tax or legal advice, and none of the statements or information on our website or sales materials should be construed as tax or legal advice. All investors are encouraged to seek advice from their own tax and legal professionals. All estimated returns on investments in FIG projects are subject to change and may be significantly different from actual financial performance. FIG is a brand used for the purposes of marketing. FIG is not an actual company but is used to brand the investment strategy used by those marketed on this website. © 2020 FIG & RE/MAX Equity

Getting a Grip on Cap Rate [Investment Math]

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 it's 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 properties 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 / 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 average vacancy rate in the area is 5%?

Capitalization Rate = ($100,000 – ($100,000 x 5%) – $40,000) / $1,000,000 = 5.5% Cap

Common Mistakes:

Most inaccuracies in calculating cap rate 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

  • Insurance

  • Maintenance

  • Trash Removal

  • Electric

  • Gas & Water

  • Business Fees

What it Isn't:

  • Depreciation

  • 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 you're 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 may 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."

Something Not Making Sense?

If you've been looking at some of our proformas found in our Current Projects page and still have a question or two—we'd be happy to clarify things for you! Send an email to Steve Olson @ solson@fig.us and he'll respond as soon as possible!

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