Real estate investing can be daunting. Every step of the process introduces concepts and complications that you may not be familiar with. It is important to identify the important ideas while also acknowledging that certain things can be revisited later.
But cap rate is one of the metrics you should understand!
What is a "Cap" (Capitalization) Rate?
A real estate investment's cap rate is the net operating income (NOI) generated by a property divided by the property's acquisition price or current market value.
Cap rate = Net operating income (NOI) / Acquisition price (or current market value)
Let's break that down in more detail by looking at an income statement for a hypothetical but realistic property.
Net operating income (NOI) is half of the cap rate equation and often requires subjectivity or estimates when evaluating a potential investment.
Gross income: Gross income is the in-place or projected rental income generated by a property before vacancy. Property's will often have existing tenants in place that a buyer will absorb. If the property (or a unit within the property) is delivered vacant, the buyer can estimate market rent for 1-4 unit residential real estate using tools such as Rentometer or Zillow.
Vacancy expense: Vacancy expense is the estimate of lost rent that will be caused by delays renting or vacancy. It is calculated by multiplying the percentage of an average year you expect the property to be vacant (often 3 - 10% for 1-4 real estate) by the gross income prior to vacancy
Effective gross income: Gross income - vacancy expense
Capital expenditures (capex): Capital expenditures (or "capex") represent expenses incurred that have long useful lives and/or increase the value of a property, such as a new roof or a new water heater. Capex expense will vary significantly from property depending on factors such as building age, previous upkeep, geographic location, tenant quality and more. It will also vary significantly from year to year, so when analyzing an investment real estate investors will often use a multi-year blended estimate.
Repairs and maintenance (R&M): Repairs and maintenance represents non-capex expenditures, such as calling the plumber for a leak or patching some siding. It will also vary significantly by property and year, though it is slightly more predictable than capex.
Taxes: Taxes are fairly self explanatory and can be found directly on Zillow or Redfin, then verified on the county or state website. One thing to look out for is tax reassessments, which may be triggered on sale and substantially increase a property's annual tax burden relative to the existing cost.
Insurance: There are many types of insurance, but the two most common are general homeowner's insurance and flood insurance. Many investors have a rule of thumb for homeowner's insurance, but flood insurance can vary greatly based on location / flood zone, so investors should check to see if a given property is in a FEMA flood zone while analyzing an investment.
Property management: Property management represents the cost paid to third parties to manage the property. For 1-4 unit real estate, it often pencils to somewhere between 6 - 15% of rental income.
Other expenses: Every income statement needs a catch-all category for expenses not encapsulated in the above categories. Common 1-4 unit other expenses include any utility responsibility, garbage and HOA.
Net operating income (NOI): With all expenses determined, you can now calculate NOI by subtracting all expenses from estimated gross income.
The numerator: Acquisition price and/or market value
Depending on the type of analysis you are doing, the bottom half of the cap rate equation can take many forms.
When to use purchase price: If you are buying a property without doing any significant rehab work, use purchase price in your cap rate equation.
When to include rehab expenses: If you plan to rehab a property, use purchase price + estimated rehab costs + X% contingency.
When to use current market value: If you are calculating cap rate for a property in your portfolio or listing a property for sale, use current market value.
Using cap rate to analyze real estate investments
Now that you know how to calcualte cap rate, you can use CF Analyzer to quickly calculate cap rate for a potential investment and compare the result to other properties in the same market.
If you analyze 50 deals and they all have a cap rate between 5.25% and 5.75%, but then you find one that has an estimated cap rate of 7% --> either something is way off (tread carefully!) or you've found a great deal.
Using cap rate to determine a property's value
Pop quiz: If you have a property generating $30,000 in NOI and the market cap rate is 5%, how much is your property worth?
Answer: $30,000 / .05 = $600,000
So cap rate can also be inverted to determine property value.
Using sensitivity analysis to analyze an investment
As an investor in 2022, I often finding myself saying "Man, that house is way overpriced" and wondering what a fair price is. While it is impossible to know what "fair" is in this market, you can use sensitivity modeling to quickly determine what a fair price is if:
- You know in-place rent or are able to accurately estimate market rent
- You know what the market cap rate is for your submarket and asset class (ex: ~5% in Jersey City, NJ)
By analyzing various purchase price and rent combinations simultaneously, you can quickly determine what a house is actually worth and decide how much to offer.
Make sure to try out CF Analyzer in order to see the sensitivity analysis tool in action.
Capitalization rate is a fundamental metric used to analyze real estate investments and now that you know how to calculate it you can use it to compare properties to each other, identify which ones to offer on and determine how much to offer.