Learn to Understand Cap Rates in Real Estate

How are you using capitalization rates in your everyday investing? 

This is one of the most popular units of measure within real estate investing. 

If you don’t know how to use it, you need to learn. 

Join us today to understand its applications.

Capitalization rate is a real estate valuation measure used to compare different real estate investments. 

Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost.

Now that you have the basis of figuring out the cap rate, let’s review its applications based upon location and available data.

Understanding CAP Rates 

Whether investing in residential or commercial investing, cap rates should be evaluated.

Cap rates are a unit of measure applicable to how your asset will grow in value over time.

It is a general basis of the investments potential performance either at the time of purchase or it’s future projection. 

Understand that a growth rate will only be applicable in a market that achieves appreciation. Your asset will either have a growth rate, a simple performance rate, if growth is not projected, or a little of both.

• In a market that does not achieve appreciation, your entry point establishes your sustained performance potential.
• In a market that has substantial sales data, cap rates can be retrieved by location. 

Urban and Urban-Outskirt Areas

Retrieving cap rates could be capable in a market that has substantial like-kind sales within a tolerable distance. If any appreciation has occurred, it can be determined within the sales data. 

Comparable sales are usually referenced on the neighborhood level, township or submarket, usually within a 1, 3 or 5 mile radius to the subject property. 

If you live in a big city, this may make perfect sense to you.

However, if you live in a rural area, the existence of substantial sales data within 1, 3 or 5 miles, may not be present. 

In order to show a historic trend, you need tens-to-hundreds of like-kind sales over time within 1,3 or 5 mile radius. 

Rural Areas

Many rural areas do not have enough sales data points to compute what the average capitalization rate would be for a particular property type in a specific area. 

When this happens, the past sales do not validate an expected performance for that area and property type. In this case, the sales data cannot be referenced as an expected performance expectation for the property. 

Expect to create a plan that makes sense for you as the investor in this scenario. Ultimately, you’ll need to decide and purchase at a cap rate that meets your expectations.

• So if the community you’re investing in, has substantial sales for apartment complexes in a 1,3 or 5 mile radius, the data may tell you that sales price compared to the assets income have sold for a “X” cap rate in this area. 
• If there is not enough volume of sales for that asset class, you will not have referenceable data to tell you how properties in that class have performed. 

These two examples are directly related to major metropolitan areas versus rural areas.

With most of the USA being rural areas, you can apply your strategy accordingly. 

If you live in a major metropolitan area, this idea may be very straight forward to you because you are used to having a pleather of data points.

City neighborhoods often have many data points which can get very specific to the cap rate and appreciation expected from a specific property type in a specific neighborhood. 

Whether you have many data points accessible to you or not, you will want to be knowledgeable enough to use the information you have, and the cap rate formula that allows you to align to your buying margins.

Let’s review the formula, also described earlier in the article.

Using the Formula

It is important that you know how to use the general formula that aligns what capitalization rate you are purchasing at. 

See the formula below.

• CAP RATE  = NOI/Purchase Price

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This cap rate formula can be manipulated in many ways. 

• Sometimes you may only have the net operating income and you’ll need to find a good purchase price. In this case, many investors know they may want to buy at a 8% cap or higher. Therefore, if they have the NOI, they will compute the purchase price they are willing to pay.
• Or you may have what the owner wants for the property and you have the net operating income. If so, you can compute what the cap rate would be if purchased at the price and income level presented.

Use this formula accordingly based upon knowing what performance level you desire and the information given.

What CAP Rate is an Indicator of…

Cap rates are supposed to be indicators of the assets’ class level. You will often hear of investors referring to A, B, C or D class asset.

“A” class is high appreciating asset and “D” class has little or no appreciation. 

In essence “A” class can also be related to a luxury product where many luxury products exist versus a “C” or “D” class property would be a property in distress, where many distressed properties exist.

So, when a CAP rate is low, at 3-5% for example, the asset should align with a A class asset with high appreciation potential.

When a CAP rate is very high, at 12% or higher for example, the asset should align with a C class asset or lower achieving little to no appreciation.

Note: It is also possible for a property to decline in value.

These cap rate percentage references are relatable to apartments. 

Other commercial property types will display other cap rate ranges for A, B, C and D class assets. Use this data accordingly. 

If you are in a rural area, specific property types may not be in abundance within a 1,3, or 5 mile radius of each other to indicate an individual property’s asset class. 

Much more research will be involved for you to determine the assets’ class versus many givens that may be delivered in a big city. 

In a rural town, you will need to verify if an asset is A, B, C, or D class, based upon the schools, median income level, access to transportation, and other amenities within the community.

Conversely in a major metro, you are usually given these variables based upon the cap rate and alignment to asset class. 

Example –

So, if you know 20 buildings within a 1 to 3 mile radius have sold at a 4% cap, you are also being told this is a “A” class asset. You are also being told that schools, transportation and access to desired amenities are close to the asset. 

Although all of these things should align, you should always verify. 

This is the difference between rural and urban data availability.

Conclusion

As you see, there are a pleather of data points and evaluation techniques to apply when investing. 

The cap rate is a highly referenced unit of measure across all property types. The cap rate should indicate the assets’ class as well. 

When understood correctly, you will understand how to apply this data to your buying criteria. Using the data will also support your research efforts.

Hopefully today’s lesson has been helpful. 

Thank you for joining us today faithful readers-future leaders. 

We wish you great success in your future endeavors. 

Love ya and keep striving for growth. 

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Please comment your experience using CAP rates and if this article was helpful.