Table of Contents
Capitalization Rate
BLOGTOBER 8
Let us start with a listing example.
I took this from loopnet.com
Some listings have more information than others. However, what they all have in common is price of the property and the capitalization rate, otherwise known as the cap rate. The arrow points you to the cap rate. Close your right eye to avoid looking at my botched up job of editing out the APN number. I am not sure if it is acceptable to have it in my blog post, so I blocked it.
This is probably the most important term, despite its limitations. It is an industry wide term. In fact, if you don’t know this term, don’t bother with real estate. It shows how much money is coming in from your investment.
The best way to understand this is to say to yourself, if I were to buy this investment property with cash, what would be the rate of return on my money?
Debt service is not included because it is based on paying for the investment property with cash. If you finance the property, you can still use the cap rate but you would have to adjust it for debt services.
Note that this is just a quick simple snap shot of a property for one year as it stands.
How to calculate cap rate?
I found this mnemonics online somewhere
IRV
Income /Rate = Value
In this case, the rate is the cap rate. If you rearrange the equation, you get
Cap rate = Income/Value = NOI /sales price.
click below for post on NOI
How to calculate net operating income
For how to calculate cash on cash return, click below
How to calculate cash on cash return
In the listing above, let us calculate the NOI for this property from the numbers we were given .
Value of the property is 2,300,000
Cap rate is 8.23%
NOI = Cap rate x Sales price
NOI = 8.23/100 X 2,300,00
NOI = $189,290
So the money you are working with every year is $189,000 . Is this an awesome amount of income? It depends on your risk level. The higher the cap rate, the higher the risk in general.
You might want to consider your alternatives before you sniffle at the NOI above
Capitalization rate disadvantages
It does not include appreciation or depreciation
Financing is not included in the calculation
Important things to know about cap rate
- As the cap rate goes up, the ROI goes up
- The higher the cap rate, usually, the neighborhood gets worse
What is a building class?
They usually grade the neighborhood as A, B and C. Ok! There is a D too but don’t worry about it, you won’t be buying any D properties.
A is the awesome neighborhood, usually consist of upper middle classes – usually cap rated <5%
B is the typical middle class – cap rates 5-10
C is usually in the “bad areas”. Capitalization rates here could be as high as 15%
What is Pro Forma cap rate?
This is based on the after repair value of the property.
In the listing above, you probably notice that the average occupancy is 94%. The agent or seller might include it in the brochure that some of the apartments need renovations. If the renovation is done, then you can rent out the other 3 apartments and have 100% occupancy. He or she might throw a cap rate of 9 or 10% at you. Also, if you paint the apartments and raise the rent, Cap rate goes to 12. What if you build a beautiful garden in front of the apartment? Cap rate of 20?
What I am trying to say here is , do not base your offer on the pro forma cap rate. Ask for the actual cap rate.
How do you use this to your advantage?
You can look for a B property in an A neighborhood, buy it and then tush it up to the standard of other apartment complexes around. You can now raise the rent and thus increasing your NOI and your cap rate.
Here is a YouTube video from BiggerPockets
I am a pulmonary and critical care doctor by day and personal finance blogger/debt slaying ninja by night.
After paying off close to $300,000 in student loan debt in less than 6 months into my real job, I started on a mission to help others achieve the same. There is no magic to this than to strap up and get it done. Some of the ways we achieved this include side hustle, budgeting, great negotiation skills, and geographical arbitrage.
When I was growing up, common knowledge in Nigeria is that there is one thing you cannot trust anyone else with, and you guessed it – your money.
Being frugal came easily to me based on my background. However, the concept of building wealth did not solidify in my mind until when I finished medical school. I wish I knew what I know now when I was 14. Still, I don’t know enough and I am constantly learning to improve my knowledge.
My goal is to reduce financial illiteracy among young professionals. I am catering to the beginners – babies and toddlers in financial literacy.
xrayvsn says
Cap rate also means two things depending on the seller or the buyer. As a buyer you want the cap rate to be as high as possible which means you got a great deal on your investment and have a good return of cash. As a seller, the lower the agreed upon cap rate sales price the better. As rising interest rates are in the future, it will likely require the cap rate to be higher for someone willing to invest (and thus sellers likely to see not as great a number than when it was during a low interest rate environment)
admin says
That’s true, like many things in finance, it is always with perspective. I worry about the interest rate a little too, how in the world did the interest rate start to climb when I now have the ability to invest in real estate. However, the way i see it is like stock market , the fact that stocks are on a high right now does not mean I wont invest in the market.
melaniepartnersinfirecom says
Haven’t done any real estate investing, but this was great information for if I want to dip my toe in! Thanks!
admin says
Thanks for stopping by. I am new to real estate myself and still learning.