New real estate investors frequently hear the term “cap rate”: how do you calculate property value using cap rate? Put simply, cap rate represents the cash-on-cash return a property generates, and I’ll use this article to explain how to actually use this number to calculate home value.
Specifically, I’ll dive into each of the following topics:
- Capitalization Rate Overview
- Apples-to-Apples Comparison Benefits
- What’s a Good Cap Rate?
- Concerns with Chasing Higher Cap Rates
- Finding Properties with Great Cap Rates
- Final Thoughts
Capitalization Rate Overview
Investors use capitalization – or cap – rates as one of three primary means of determining property valuation (with the other two being the market comp and cost-to-construct methods). Typically reserved for commercial properties, cap rates determine value from a property’s income – the reason why investors often refer to this as the income approach to valuation.
Conceptually, cap rates represent the cash-on-cash returns a property would generate. That is, if an investor purchased a property without a loan, he or she would receive a return equal to the cap rate. Put in other terms, cap rates tell you what you get out of a property without any debt on it.
Mathematically, cap rate equals a property’s net operating income (NOI) divided by its value (or purchase price for a newly acquired or target property). And, for residential properties, NOI consists of total rents minus total operating expenses (property taxes, insurance, management fees, etc). Of note, NOI does not include any debt service (loan principal and interest payments).
For example, assume an investor wants to purchase a quadplex listed for $500,000. After analyzing the numbers, the investor determines that the property’s NOI will be $25,000 (an annualized number). As such, the cap rate equals $25,000 NOI divided by $500,000 purchase price, or 5%. This means that, if this investor paid all cash to purchase this property, he or she would receive a 5% annual return on that $500,000 investment.
Apples-to-Apples Comparison Benefits
With most residential properties, investors use some sort of home value estimator to both determine value and compare multiple properties. However, comparing properties based on value alone fails to provide investors key insight, as it fails to compare the profitability of these different properties.
On the other hand, cap rates provide investors an apples-to-apples – or standardized – metric for comparing the profitability of a diverse set of properties. For example, if an investor wants to decide between a duplex for $300,000 or a triplex for $350,000, those purchase prices don’t provide the necessary decision-making support.
But, if that same investor determines that the duplex has a cap rate of 7.5% and the triplex a cap rate of 4.5%, it becomes obvious that purchasing the duplex will generate greater returns. This comparability represents the beauty of cap rates – they provide investors a decision-making tool that home values alone do not allow.
What’s a Good Cap Rate?
A good cap rate will vary depending on whether you’re selling or buying a property. For a seller, a lower cap rate is better, as this means the valuation (the denominator) is larger, therefore you’ll receive more money in the sale. Conversely, for buyers, the higher the cap rate the better, as this means the profitability of the property increases.
Having said that, here’s what I shoot for in terms of analyzing rental properties for purchase:
- Minimum cap rate: 5%
- Target cap rate: 8%
- Outstanding cap rate (assuming decent neighborhood): 10% or higher
For example, let’s say I find an awesome looking duplex in a great neighborhood for $250,000. In analyzing the deal, I’d require a minimum NOI of $12,500, as this would lead to a cap rate of 5%, my minimum ($12,500 / $250,000 = 5%). So, if I run the numbers and project an NOI of $8,000 (3.2% cap rate), I know that this deal doesn’t make sense. On the other hand, if I project an NOI of $25,000 (10% cap rate), the deal could be a home run.
Once again, this shows how cap rates can be such a great tool for investors. They provide an easy-to-calculate, easy-to-understand, and standardized means to analyze a property’s profitability.
Concerns with Chasing Higher Cap Rates
But, now that I’ve explained cap rates and talked about their benefits, I need to provide a word of caution about blindly chasing higher cap rates.
Unfortunately, investors can find some of the highest cap rates in older, maintenance-heavy neighborhoods. As a result, a property may have an outstanding cap rate, but if you fully analyze the deal, you’ll likely realize that these benefits will be outweighed by the significant amount of upkeep and tenant attention a property will require.
Most real estate investors begin investing to have more free time to do other things. Purchasing a time- and labor-intensive property can crush this goal before it’s achieved, as investors will find themselves pouring a ton of time, money, and effort into a single property. A high cap rate likely will not adequately compensate you for these troubles.
But, if investors do want to pursue one of these properties, using a top-notch property management company – as opposed to managing the property yourself – can offset these additional troubles. In other words, while a property may require a ton of attention, it won’t be your attention, as the property management company will handle problems as they arise. As with any services, investors need to pay for a property management company, but this additional expense provides tremendous peace of mind and convenience for investors.
Finding Properties with Great Cap Rates
Now, let’s get to where the rubber meets the road – actually finding properties with great cap rates.
Unfortunately, when you work solely through a local MLS to find good investment properties, you significantly limit yourself, as these properties often have mediocre cap rates, at best. And, due to their presence on the MLS, you need to compete with every other investor – and primary home buyer – for outstanding investment opportunities that occasionally do pop up on the MLS.
This reality means that investors need to find off-market properties for some of the best possible cap rates, something I’ve been doing both personally and at The Investor's Edge for years.
And, while this strategy takes some extra research and marketing leg work, we’ve developed an outstanding software solution – our Investor’s Edge software – to provide you the support and insight necessary to find the best off-market properties.
In addition to providing investors access to millions of properties, this software also provides the analytical support to help you calculate cap rates – and compare them against as many potential properties as you want.
Final Thoughts
Investors shouldn’t only use cap rates when analyzing a property. As discussed above, you also need to assess the overall quality of a property to help determine how time- and labor-intensive an investment it will be.
But, when it comes to comparing multiple properties, cap rates serve as an absolutely indispensable tool. They let investors – with a single number – compare the projected profitability of multiple properties, no matter how similar or different.
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