Let’s Talk about Cap Rates
Determining the capitalization rate for a real estate investment property—usually referred to as simply cap rate—involves a fairly simple calculation. Determining whether or not the answer means you should invest or not isn’t quite so simple. As with most investments, there are always other factors to consider, but knowing the cap rate on a property is a good starting point.
What is a Cap Rate?
A cap rate is a frequently used and versatile tool in investment analysis. It can be used to measure the potential return on a real estate investment or to determine the market value of a property. Cap rates are typically expressed as a percentage. Lower cap rates indicate that the overall risk assessment and return on investment are low. Conversely, the higher cap rates indicate high risk and return. For example, a brand new apartment complex in Uptown Dallas will have a low cap rate. Rents are increasing, occupancy is high, and development in the area is continuing. The overall risk assessment is low. But, if you want a low risk investment, you’re going to have to pay extra for it.
How is Cap Rate Calculated?
To arrive at the cap rate on an investment property, the net operating income, or NOI, is divided by the current market value, or sales price. (The NOI is equal to revenue from the property minus operating expenses.)
So for example, let’s say you’re considering buying a 15 unit multifamily property for $1,400,000. You anticipate rent will be $1,100/month per unit for a yearly total of $198,000, and that the annual operating expenses will be $83,000.
Using these figures, the NOI is $115,000 ($198,000 – $83,000).
Now, to calculate the cap rate, the NOI is divided by the current market value, or $115,000/$1,400,000 = 8.21%.
What is a Good Cap Rate?
Generally speaking, most experts agree that a cap rate around 8% is good. However, according to the 2018 Trends Report, published by Henry S. Miller, cap rate for multifamily properties in DFW can range from 4.2% to 9%.
A general rule of thumb is to try to maintain at least a 2-point spread between your cap rate and cost of funds. If you are trying to buy a property on an 8% cap rate, your interest rate on the loan needs to be at most 6%. The bigger the spread, the more money in your pocket.
What is an Acceptable Cap Rate for Your Property?
That all depends. The type of property you are considering can affect the cap rate. Take multi-family housing, for example. These almost always have lower cap rates because the larger number of tenants generating rental income reduces your risk. Conversely, a property with a single tenant presents a greater risk.
In addition, different markets have different cap rates. Why? Because:
- Rents and operating expenses differ between states, cities, suburbs and neighborhoods
- The price of property changes from one location to another
- Supply and demand is different from market to market
Therefore, always compare the cap rate on a potential investment property to several other comparable properties in the same market.
The information contained in this article is general in nature and should not be construed as financial, tax or legal advice. As with any financial or legal matter, consult your tax advisor and legal counsel.