What is a Cap Rate in Real Estate?

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What is a Cap Rate in Real Estate?

You may have heard people talk about a capitalization rate (or cap rate) when buying or selling real estate investments. If you’re anything like me, the first time you heard this term you went directly to Google and searched, “What are cap rates?” 

Today I want to clarify what a capitalization rate is, why cap rates matter (or don’t), and why this is particularly important to watch out for if you’re investing in large apartment syndication.

Cap Rate Definition

A capitalization rate is the estimated rate of return – expressed as a percentage – that a property will produce if the property is purchased in cash. (source)

Capitalization rates are a way to determine how much a property should be worth based on the income it produces. Cap rates move in the opposite direction of the purchase price, so the higher a cap rate is, the lower the purchase price will be. Conversely, the lower a cap rate, the higher the purchase price will likely be. 

A building that produces $100,000 in annual net operating income will be worth a significantly different amount depending on the location of the building. 

If that building is located in a market where the cap rate averages 8 percent, it may be worth $1,250,000.

On the other hand, if that building is located somewhere with a 4 percent cap rate, it would be worth $2,500,000.

This is a significant difference, which is why you need to become an expert in your local market and be sure you understand the cap rates there!

If you’re anything like I was when I first asked Google “What is a cap rate in real estate?” this definition didn’t really help, haha.

The Cap Rate Formula

So what is a cap rate? Well, to understand that you need to know the cap rate formula!

To determine the cap rate of a building, you simply divide the annual net operating income (NOI) by the purchase price. 

 

what is a cap rate in real estate - cap rate formula

For example, if you bought an apartment building in cash (unlikely) for $1,000,000 that produced a net operating income of $100,000 annually, the cap rate would be 10 percent. 

$100,000 annual NOI 

÷ $1,000,000 purchase price

= 10% capitalization rate

If you were able to purchase this same property for $909,090, the cap rate would be closer to 11%. And if you purchased it at a 9% capitalization rate, the purchase price would be $1,111,111. 

What is Net Operating Income

The net operating income is an important part of calculating capitalization rates, and I want to ensure you know how to come up with this number. 

Net Operating Income (NOI) formula

Net Operating Income is essentially the annual gross rental income minus every single expense except for debt expenses (principal and interest payments on your mortgage). 

The fact that NOI excludes debt expenses actually makes the cap rate formula more useful. This way it focuses on how the market and asset are performing without throwing in financing, which allows for an even comparison across the market. 

There are so many different kinds of financing that it would be impossible to make an apples-to-apples comparison of commercial properties if you accounted for how you plan to finance properties.  

Capitalization Rate Calculator

What Are Cap Rates? 

Alright, now that you understand how a capitalization rate is determined from a mathematical standpoint, what is a cap rate really?

A cap rate is an arbitrary number that people use as a simple way to express the market value of the commercial real estate. 

In layman’s terms, a cap rate makes determining the market value of large assets simpler. 

An important caveat here is that cap rate should never be the driving factor for how you purchase an apartment building. Don’t blindly ask what the average cap rate is in a market and then offer a price that reflects that. Instead, use the cap rate to understand what properties have been selling for and the general market sentiment. 

Finally, it is important to mention again that cap rates do not include any debt (mortgage) expenses!

Does Asset Class Matter for Cap Rates?

Yes. 

The asset class absolutely matters when comparing cap rates. 

A high-end apartment complex that would be considered a class A asset is absolutely going to have a lower capitalization rate than a class D asset that is located in a “war zone.” 

For example, in the market where I invest, you may see capitalization rates ranging from as low as 5 percent to as high as 12 percent, depending on the asset. 

For example, and this is only a speculative example for educational purposes only…

Class A assets: 4-6 percent cap rates

Class B assets: 6-8 percent cap rates

Class C assets: 8-10 percent cap rates

Class D assets: 10+ percent cap rates

What these different asset classes are actually valued at will be different in your market and will fluctuate periodically. A good way to determine this in your market is asking a few active commercial real estate brokers. 

Real Estate Asset Classes

Here is an abbreviated overview of the different real estate asset classes. These are somewhat subjective, but at least this will give you a better idea of different kinds of properties and their potential values. 

Class A assets: These are the most prestigious properties in a market, and they demand above-market rent. These are properties like luxury apartments, high-end condos, and other high-class properties with great amenities. They are the places everybody would love to live if they could afford it. 

Class B assets: These are generally 20-40 years old and appeal to people from all walks of life. They attract average rent and appeal to higher-end tenants even though they can’t compete with luxury assets. 

Class C assets: These are functional properties that are often 40+ years old and have slightly discounted rental rates when compared with newer assets. These are generally rented by blue-collar working-class people. 

Class D assets: These are the properties that nightmares are made of. Okay, maybe they aren’t that bad, but they definitely aren’t something you should own if you’re faint of heart. These are often located in the worst part of town and in higher crime areas. These properties might be valued at a higher cap rate, but it is because of the headaches that inherently accompany owning them. 

What Are Good Cap Rates?

Here is a quick look at the capitalization rates for class A stabilized multifamily properties in the second half of 2019 across the United States.

what are good cap rates?

As you can see, these property values fluctuate quite a bit even across Tier 1 cities with the same asset class.  

I show you this to drive home the fact that a “good cap rate” is going to depend on the market where you invest and your particular real estate strategy. 

If you were able to buy a stabilized class A property in any of the markets above at an 8% capitalization rate, that would be a steal. However, if you bought a class D property in the same city at an 8% cap rate, it might be a huge rip off!

This is why you need to become an expert in the market and asset class in which you invest. The more you can keep your finger on the pulse of your market and current cap rates in the area, the more prepared you will be to make an offer when properties pop up for sale. 

In short, the answer to, “What is a good cap rate?” is, “It depends on the market, property type, and your personal investing strategy.”

How Does Property Type Affect Cap Rates?

There are a lot of different property types out there. When the economy heads toward a recession, apartment complexes generally do fairly well because people will always need a place to live.

This makes sense when you think about it. 

If you just lost your job, are you more likely to quit going to the mall or quit paying for a place to live? Most likely (and hopefully), you said that you will pay for a roof over your head and forego shopping at the mall. This is what most people do, and it is reflected in capitalization rates across various property types. 

Average cap rates by property type

Cap rates obviously vary a lot by property type, as well as all of the other macro and microeconomic factors that we have discussed. This is just another reason for you to become an expert in your desired investment strategy. 

What Are Cap Rates Used for in Syndications?

When a group of investors pool their money together to purchase an apartment complex, it is most commonly done in what is known as syndication. Capitalization rates play a large role in syndication investments because of how much a cap rate can affect your entry and exit sale prices. 

Watch Out for This Cap Rate Trick!

The reason you need to understand how capitalization rates affect multifamily syndication is so that you don’t get screwed when investing with them. Let’s say the person you are investing with believes the market capitalization rate will be 6% when you plan to sell the asset after five years of ownership. If the average cap rate is 8%, that could effectively erase any return on investment you were expecting to receive. 

While it is impossible to guess with 100% accuracy what the market will look like in five years, it is possible to make pretty educated guesses. 

For example, if the market you’re investing in has seen significant expansion and cap rates have compressed – meaning they have lowered, and property values have risen significantly – it is probably safe to assume the cap rate in five years might be a little higher than it is now. 

If you see that a market has very compressed cap rates, you’re purchasing a property at full market value at a 4% cap rate, and the acquisition details predict cap rates will be 3% when you sell…run!

Okay, maybe you don’t need to run, but you need to understand that if capitalization rates aren’t 3% when you plan to sell, you may either need to sell for less than planned or hold onto the property for a lot longer. 

This is a good trick to pay attention to, as that single number can drastically change the return on investment you plan to receive from syndication. 

The more you know!

What Does Capitalization Rate Mean? 

This is less pertinent, but when answering “What is a cap rate in real estate?” I think it is still important to know what capitalization rates mean on from a 5,000-foot view as well.

A cap rate is a way to value real estate based on macro and microeconomic factors, as well as the type of property. 

I know we have already covered this, but I want to reiterate once again that the cap rate is simply a way to value real estate in an apples-to-apples comparison nationwide. 

Don’t ever purchase a property based solely on the capitalization rate. You owe it to yourself to conduct a full analysis of any property you intend to purchase. 

Do Capitalization Rates Matter?

Maybe?

Cap rates absolutely play a role in the purchase and sale of commercial properties such as apartments, hotels, strip malls, and more.

However, cap rates aren’t necessary on single-family rental properties at all. You could definitely use a cap rate if you wanted to compare your single-family rentals to an apartment complex ROI in an apples-to-apples manner, but you don’t need to. 

I couldn’t care less what the cap rates are on my single-family, duplexes, and other small rental properties. Residential properties like this are valued differently, and I’ve never used a cap rate to evaluate them before. 

The Bottom Line about Capitalization Rates

Capitalization rates are a tool to help you determine the value of an asset in a given market. 

They are not, by any means, the only tool you need to use when deciding whether or not to buy a property. 

You should always conduct a full analysis before buying any real estate investment, and consult with your team and the professionals in your market too! 

I hope this article answered “What is a cap rate in real estate?” once and for all. If you have any further questions, don’t hesitate to ask them in the comments section!

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David Pere

David Pere

David is an active duty Marine, who devotes his free time to teaching personal finance and real estate investing for service members, and the working class!

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