The cap rate demystified…

When evaluating several properties to purchase, whether you’re investing in rental property or commercial real estate, experienced property investors use a cap rate formula to help crunch their numbers. Ultimately, the cap rate (more formally known as the capitalization rate) aids the investor in analyzing what property makes the best deal. It is used simply as an indicator – a directional arrow – as to which property SHOULD offer the best yields, and throw off the most profit for you in the future. However, a controversy has brewed of late about how much investors should rely on the cap rate.

What is a cap rate exactly?

A simple cap rate definition would be that the real estate cap rate is a calculation that measures the annual rate of return for any given investment property, or set of investment properties. The cap rate for any geographical area will differ, with the general axiom that the more in demand the area is, the greater the cap rate will be. These hotter markets tend to offer yields with cap rates around ten percent or more. However, low demand areas may throw off cap rates as low as four percent.

How to calculate cap rate

I have previously written about how to calculate the cap rate here. I have noted that the calculation for the CAP rate is easy; simply follow this order: ascertain the annual rent roll from a given investment property (making sure to double check and confirm any seller-given figures). If there are vacant property investor units in the building, you’ll need to ascribe a correct market rent for each unit. Make sure you check out several Realtor’s estimates, Craigslist listings, and have actually visited like units in other buildings to help determine accurate rent roll pro forma numbers. Then add up all the expenses associated with the building, on an annualized basis.

I had also mentioned that you should not forget a vacancy amount (usually between five to ten percent of total rent roll), as well as maintenance, taxes, insurance, electric, heating, and any other utilities the tenant will not be paying directly for. Of course, unless you’re paying all cash for the property, you’ll need to add in your mortgage payment on an annualized basis as well. Once you subtract the total expenses from the pro forma total income, you’ll have your (hopefully) positive cash flow number. This, of course, is your net income.

Cap rate calculation

Now simply divide the net income figure by the amount the seller is asking for the property. (As an example, if a property that throws off $50,000 in net income has an asking price of $500,000, then the CAP rate would be $50,000/$500,000, or 10%.) To reiterate, the greater in demand the area, the greater the CAP rate should be. In addition, you need to set minimum standards for yourself. Some investors won’t buy anything with a CAP rate below 5%. That’s up to you. But be sure to use the CAP rate to help you back into the highest amount you would offer for a property. The CAP rate can represent your rate of return on any given investment property.

At the beginning of your investment property search, a novice may initially want to use pen and paper, however, there are many real estate investment calculator programs readily available online to do the calculations for you. Simply plug in your specific numbers to software programs that act as a cap rate calculator…one of them is right here in the Tools section – and let them do all the numbers crunching for you…

Here’s the crux of the cap rate controversy…

Some real estate investment pros believe the cap rate to be too short-sighted…like looking at a landscape with a telescope. One such critic of cap rates is W. Grayson Powell, a broker and managing partner with Coldwell Banker Sun Coast Partners. In an article he wrote last year ( “Property Investment Cap Rates Aren’t Always Accurate, “ Wilmington Biz.com, September 1, 2014), Mr. Powell noted that “cap rates are solely based on property income performance for the current year. Cap rates don’t take into consideration factors that may affect property values five years or 10 years down the road. Because cap rates only deal with what a property is producing now, it’s a very shortsighted and narrow view of property value and should not be the number on which you ultimately base your purchase price.”

Like buying a used car?

He goes on to compare cap rate analysis with your decision-making process when buying a used car. He adds that “cap rates on income properties are often like the list price of a used car. They can be an indicator of the estimated value of the property and give you a starting point for your search, but there is more information and more work to be done before choosing a property and making an offer.” Mr. Powell then notes that “there are many factors to consider when determining and fine-tuning property valuations. Here are a few of them:

• How good are the existing leases? A reputable grocery store with a 20-year lease is low risk; but a restaurant that’s empty most of the time with one year left on its lease is much riskier.
• Is there a good tenant mix and do they effectively serve the needs and interests of the surrounding community? The demographics of a community can change, and the types of tenants must evolve to match the needs and demands of the people in the area.
• What is the age and condition of the property? How soon will you have to pay for upgrades and repairs?
• What is the current housing market and financial environment like? Are rental rates rising or falling?
• What are the current interest rates and what are they expected to be in the coming months?
• Are operating and management expenses rising or falling? Here’s a hint – they’re usually rising.
• What are the historical occupancy, retention and vacancy rates for the property over the last 10 years to 15 years?
• What are the tax implications of buying a particular property?”

Finally, he goes on to recommend “analyzing the cap rates and the values of each individual tenant, rather than looking at the property as a single entity. This provides a better picture of the actual risks that exist within a given property.”

The fallacy of his argument

My opinion is that, while all of his assertions are correct, he loses sight of the main reason why a property investor uses the cap rate: namely, to analyze what the investor should be offering to pay for any given investment property. Obviously, this will be highly subjective from investor to investor. However, keep in mind that, when a piece of investment real estate goes on the market for sale, the asking price of that investment property is pegged to a point in time.   It’s not the asking price ten years from now. And the asking price usually bears some relationship to the prior year’s income performance of the property….and not to the performance in ten years.

And this is the main fallacy with Mr. Powell’s argument. I think it’s absolutely fair to consider a property’s short term performance utilizing the cap rate in so doing – because the cap rate will reflect the underlying value of the property today – when the asking price is set. After all, the asking price is not set some time down the road. As I mentioned earlier, you’ll be taking into account vacancy rates for the area when you figure your cap rate. And you’ll also be analyzing the future revenue potential of a property based on your expectations of what renovations will be needed to bring in current market rents, or how the rental market in general will perform down the road as well.

 

photos courtesy of hudsoncreg.com, joelane.com, denalipm.com, sanpedrosquareproperties.com, sultharproperties.com, usnews.com, mortgage.lovetoknow.com, whatsthepointofaventura.com