When purchasing real estate for personal use, such as your home, you select the neighborhood you want to live in, determine your budget, and begin looking at houses in your price range, perhaps with the assistance of a realtor. Major factors impacting prices in a given neighborhood include the square footage of the home, its age, the quality of the construction and finishes, and amenities (i.e., number of bathrooms, fireplaces, outdoor space). To compare units in the same building, or similar properties in a neighborhood, the price per square foot is a good metric.
Properties for investment, however, are more commonly compared using their capitalization rate, or “cap rate.” The cap rate is the rate of return on your investment, based on the income of the property as compared with the purchase price.
The net operating income (NOI) is the net income generated by the property, usually from tenant rents, less the amount of taxes and any operating expenses, such as insurance and utilities. The purchase price used in the formula is the fair market value of the property, excluding any transaction and loan costs. So for example, a property that generates $300,000 in annual net income listed for sale for $5.5 million is being offered at a cap rate of 5.45 percent. If the transaction closed at this price, the investor could be receiving a 5.45 percent annual return on the investment.
The higher the cap rate, the greater the cash income you will receive from the property (or, put differently, the less you will pay to acquire the asset in relation to the anticipated cash flow). While the price per square foot may be a consideration, cap rates are more frequently used to evaluate commercial properties because most investors are buying them for the cash flow rather than for their own business operations. Cap rates enable investors to compare the prices of different buildings in different locations with the same tenant (i.e., a new Walgreens in cities A, B and C), or nearby properties with different tenants (i.e., Walgreens, CVS and Rite Aid). Factors affecting the cap rate also include the creditworthiness of the tenant(s), whether there is a corporate guaranty and by whom, and the length and terms of the leases.
Note that the cap rate does not always indicate an investor’s actual return. Capital expenses that may be the owner’s responsibility are not taken into account in the cap rate, nor are loan costs, closing costs and other transaction fees. The investor’s return may also be improved by using leverage, but mortgage debt is not considered in calculating the cap rate.
Additionally, the cap rate is based on the market value and income generated by the property at the time of sale; it does not take into account prospective changes in the operating income of the property, or changes in the underlying market value. In the example above, if the annual NOI were to increase to $400,000 per year, the investor’s return would be 7.27 percent for that year ($400,000/$5,500,000). However, NOI could also decrease, whether as a result of tenant vacancies or unfavorable shifts in rental rates under new or existing leases. This is especially important to consider if your tenant’s lease is due to expire in the near future. Similarly, if the income stream remained constant at $300,000 but the value of the property itself rose, say to $6 million, the cap rate for a sale at that point in time would be only 5.00 percent. Remember that a cap rate is only calculated at the time of a purchase or sale, it is not a characteristic inherent to a property.
The use of cap rates for evaluating investment properties does not mean that the factors typically considered for homes and other personal use are irrelevant – they are certainly important to examine closely before buying any real estate. However, an understanding of cap rates will enable you to better compare commercial acquisition opportunities.
Editor’s Note: If you enjoyed this article, we also suggest this webinar about real estate deals featuring the expert faculty of Financial Poise Webinars.
Interested in Real Estate Investing? Start Here
How to Leverage Real Estate Investments
Trust me! How to Evaluate Sponsors of Real Estate Investments
Real Estate Due Diligence: A simple guide for investment properties
Real Estate Syndication: A Simple Guide
Myth vs. Reality: Real Estate Investments and 1031 Exchanges