Cap rate to real estate investing is like the true North to a compass; it is your first and most obvious indicator of whether an investment property is worth investing in or not.
Although there are many different ways to evaluate an investment property and to project its returns, cap rate is the number 1 metric used by real estate investors when making decisions, designing investment strategies, and deciding whether a property is a good investment or not.
How to Evaluate an Investment Property?
There are a number of methods that real estate investors use to evaluate an investment property. An investment property can either be evaluated based on its functionality and property type, including the location of the property and its potential for appreciation, or based on its projected returns – the profit that the investment property is expected to make.
When it comes to evaluating investment properties based on their projected returns, real estate investors have come up with a number of metrics and equations to calculate the returns of a property and determine how much profit that property is going to make for them. While different investors and real estate agents and brokers might resort to different evaluation methods, the main metric used by most real estate investors and other real estate professionals is cap rate.
So, what is cap rate? And how can it be used to estimate the returns of an investment property to decide whether or not that property is a good real estate investment or not?
What Is Cap Rate in Real Estate Investing?
The capitalization rate is the most commonly used metric for the assessment of an investment property and measuring its returns.
In short, cap rate (capitalization rate) is the ratio of NOI (Net Operating Income) to the property asset value.
The value of capitalization rate is typically a percentage based value, and higher cap rates often indicate higher return on investment but also a higher level of risk associated with that investment.
As a simplified example of what cap rate really is, consider a rental property with a price point of $100,000 which has an NOI of $10,000/year. The cap rate for this rental property would be 10%, and it would mean that this property needs 10 years to generate a profit that is equal to its price, or to capitalize the investment.
How to Calculate Cap Rate?
Going back to our previous example, this is what the cap rate equation would look like for that rental property:
Capitalization Rate = Annual NOI/Cost of the Property
Capitalization Rate = $10,000/$100,000
Capitalization Rate = 10%
While these numbers might not seem realistic, it is a simplified example to showcase how cap rate is calculated.
But, to make it more relevant to the current real estate market, let’s suppose that an investment property costs $17,000,000, and its NOI is $1,000,000.
The cap rate for this investment property would be $1,000,000/ $17,000,000 = 5.8%.
While this might seem like a low value, with more experience in real estate investing you will be more capable of determining what a good cap rate is and what you’re trying to find. You will also be able to assess an investment property and determine the level of risk associated with it based on its cap rate value, allowing you to target specific properties based on your own investment strategy and criteria.
What Is Considered Good Cap Rate?
The cap rate typically varies based on the type of the investment property that you’re going for. Multi family homes, for example, normally have the lowest cap rates, but they also have the lowest risk associated with them. That is because an apartment building, for instance, might have one or two vacant units without drastically affecting its cash flow, making it a less risky investment than let’s say a luxury home.
Additionally, capitalization rate can also be different depending on the housing market. Different states, cities, or neighborhoods might all have different cap rates based on several different factors, such as average rents, operating costs, and also different levels of supply and demand.
What’s the Difference between Cap Rate and Cash on Cash Return?
Different real estate investors choose to rely on different valuation metrics to assess an investment property’s returns. In addition to capitalization rate, several investors use another metric, cash on cash return, to determine a property’s return on investment.
So, what is the difference between cap rate and cash on cash return?
One part that is missing from the cap rate calculation is the method of financing. Calculating cap rate is usually based on the assumption that the rental property was paid off all in cash, not taking into account any borrowed money through a mortgage or a loan.
Cash on cash return, on the other hand, calculates the return on investment based only on the amount of cash that you’ve paid, leaving out any borrowed money.
Now let’s go back to the example from before:
You want to buy a rental property that is priced at $17,000,000 and is expected to have an annual NOI of $1,000,000. You decide to obtain a loan to cover 80% of the total price, while you pay 20% in cash. This means that the cash you’re paying for this investment property is $3,400,000.
In order to calculate the cash on cash return, we’re going to use a similar equation, but instead of using the total price of the property, we’re only going to use the money that you paid in cash.
Cash on Cash Return = Annual NOI/Cash Paid
Cash on Cash Return = $1,000,000/$3,400,000
Cash on Cash Return = 29%
As you can notice, if you’re financing your investment property through a loan, your cash on cash return value will always be higher than your capitalization rate value.
Related: What is a Good Cash on Cash Return?
Both capitalization rate and cash on cash return are important metrics for evaluating and estimating the returns on your investment property. In order to determine the best investment properties, real estate investors prefer to use a combination of the two metrics in order to gain a better idea of whether a rental property is worth the investment or not.
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