Essential Real Estate Calculation #2: Capitalization Rate (Cap Rate)
For investors that aren’t already familiar with Real Estate Syndications, it involves multiple investors pooling their capital together to purchase no-hassle, hands-off investment properties that deliver passive income and appreciation to the investor. For additional details on real estate syndications, we recommend checking out the following blog posts:
One of the keys to selecting a great real estate syndication investment is performing due diligence and detailed analysis on the Sponsor, Market, and the Property. Our team here at Limitless Investing independently reviews every syndication opportunity prior to sharing with our investors to ensure they are only receiving high-quality, pre-vetted opportunities.
With that said, we believe it is important for investors to understand the Essential Real Estate Calculations that are utilized as part of this analysis. In the previous post we reviewed Net Operating Income (NOI) and today we will be exploring the second calculation: Capitalization Rate aka Cap Rate
What is a Cap Rate?
Cap rate measures the rate of return generated by investing in commercial real estate such as apartment complexes. This calculation represents the yield of a property over a one year time horizon assuming the property is purchased on cash and not on loan. Simply put, the cap rate indicates the property’s intrinsic, un-leveraged rate of return.
Why is a Cap Rate important?
Cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. This is why it is key for real estate investors to understand this metric.
Another key component of a cap rate is that it can then be used for comparing multiple real estate investment options that have different characteristics such as: location, number of units, revenue, expenses etc. By using the cap rate, investors can combine multiple factors, normalize the data and make a relative comparison of value.
How do I calculate a Cap Rate?
To calculate the cap rate, you simply divide the property’s net operating income (NOI) by the current market value or sale price.
Capitalization Rate = Net Operating Income / Current Market Value
For example, let’s say an apartment complex has a net operating income of $500,000 and the current market value is $10,000,000. Using the formula above, here’s the calculation:
Capitalization Rate = $500,000/ $10,000,000
Capitalization Rate = 5% aka a “5 cap”
Let’s say a different property has a net operating income of $800,000 and the current market value is $20,000,000:
Capitalization Rate = $800,000/ $20,000,000
Capitalization Rate = 4% aka a “4 cap”
As we can see, different cap rates among different properties, or different cap rates across different time horizons on the same property, represent different levels of risk and associated return. A look at the formula indicates that the cap rate value will be higher for properties that generate higher net operating income and have a lower valuation, and vice versa.
While it may seem obvious to invest in properties with higher cap rates, typically the properties with lower cap rates have a higher potential for growth, which is why they have a higher valuation. This is why cap rates should be evaluated in conjunction with other key metrics to provide a more complete picture of the property’s investment potential.
And there you have it! You are now armed with one of the most essential real estate calculations. If you’d like to explore how no-hassle, hands-off real estate syndications can offer attractive cap rates, don’t hesitate to reach out to discuss your investing goals and subscribe to our blog for future content!
If you’re interested in learning more about investing in a real estate syndication, download your free copy of our eBook, Achieving Financial Freedom by Investing in No-Hassle, Hands-Off Real Estate