We consider the cap rate to be one of the “golden ratios” in real estate investing. Find out what it means and why it is so important.
What is a Cap Rate?
A capitalization rate (also known as “cap rate”) is used in real estate investing to determine the rate of return a property is expected to generate.
How to Calculate Cap Rate?
Cap rate is calculated by taking the net operating income (NOI) and dividing it by the current market value of the property.
Cap Rate = Net Operating Income / Current Market Value
The net operating income (NOI) is the expected annual income generated by the property (e.g. rental income, laundry income, other income), subtract the expenses incurred on the property (e.g. maintenance, repairs, snow removal, insurance, taxes). It is important to note that NOI does not include mortgage payments.
The current market value of the property is the present-day value of the property. If you are calculating the cap rate on a property you already own, the current market value would be determined by using comparable properties, or better yet, a property appraisal.
If you are calculating the cap rate for a property you are interested in purchasing, this number would be the list price or the price that you are considering to offer.
Cap Rate = Net Operating Income / Purchase Price
What is a Good Cap Rate?
Historically, real estate experts would advise to only acquire properties with a double digit cap rate (i.e. 10%+). However, in recent years, with the boom of the real estate market, finding properties (in good locations) with a double digit cap rate has become near to impossible.
In some markets, finding multi-family homes with a 10%+ cap rate is possible, because the property is generating a high amount of income compared to the market value. However, these are commonly in rough areas – and remember the #1 rule of real estate investing? Location, location, location.
In Southwestern Ontario in 2022, a “good” cap rate in a good location is considered 5%+. The average rental property is trading for a 3-4% cap rate.
What does the low cap rates mean?
The lower the cap rate, the lower the return you are earning per dollar in that investment. In other words, the lower the return on investment (ROI) is.
Be weary of when brokers/agents provide cap rates
There are several items that factor into the calculation of the cap rate. Proceed with caution when a selling agent provides a cap rate, since it can be exaggerated. We suggest that you calculate your own cap rate.
For example, since NOI is calculated based on income minus expenses, the expected annual income can be exaggerated by anticipating a 100% occupancy. It would be great if your property was rented 100% of the time, but we all know tenants move out, and sometimes finding new, qualified tenants can be challenging. We suggest doing research in the local submarket to find out historical vacancy rates . At Coachwood Capital, we use the average vacancy rate in the local submarket over the previous 5 years. When in doubt, be conservative and overestimate your vacancy loss.
Another example of when a cap rate can be exaggerated is by underestimating expenses. In Coachwood Capital, we calculate expenses using all of the following:
- Property taxes
- Utilities (if owner paid)
- Snow removal and landscaping/grass cutting
- Property management (typically 3-5% of income)
- Maintenance/repairs (typically 3-6% of income)
- Condo fees (if applicable)
- Other expenses
Be weary to use the expenses from the previous owner because they may underreport some of the figures. We suggest finding up-to-date tax and insurance information, and finding out any upcoming increases to condo fees.
How to determine an offer price based on a target cap rate:
At Coachwood Capital, we look for properties in Class A locations in the U.S. with a cap rate of 6%+. After performing our due diligence and knowing what the anticipated income and expenses are (therefore the NOI), we can calculate an offer price accordingly using the following formula:
Offer Price = NOI / Target Cap Rate
For example, let’s say that a property is listed for $10M, and the annual NOI is $500,000. The cap rate listed would be 5% ($10M/$500k). Let’s say that you had a target cap rate of 6%, then take the NOI of $500k and divide that by 6% to get $8.3M. This would be your offer price.