What is capitalization rate in real estate
Cap rate is the key financial measurement for valuing commercial real estate. Knowing how to calculate and use a cap rate is critical for any real estate investor to master.
About the author: Andrew Syrios is a real estate investor and writer living in Kansas City, MO. He is a partner in Stewardship Properties along with his brother and father. Their company owns just over 500 units in four states.
Capitalization rate, or cap rate for short, is the key financial measurement for valuing commercial real estate. Knowing how to calculate a cap rate and how to use to it to evaluate a potential investment property is critical for any real estate investor to master.
So, what is a cap rate? The cap rate is a way to measure the return you can expect from an investment property. Normally, when buying houses to flip or buying to hold, the technique to value a property is to look for comparable properties and adjust for any differences (i.e. square footage, number of bathrooms, etc.). But with commercial real estate and apartments, there are rarely properties that are similar enough to be compared like this. How do you compare, for example, a 20-unit apartment that has only 2-bedroom units with a 50-unit apartment that has only 1-bedroom units?
Enter the cap rate. The cap rate compares what kind of return you get on your investment in the property. By comparing the return, you can compare two apartments or commercial properties even if they have some significant differences. Cap rates are also useful for houses and smaller apartments to verify the property cash flows and the valuation based on comparables.
Right off the bat though, there’s a problem. What if one property is highly leveraged and another has no debt on it at all? This would dramatically change both how much money is brought in (because one property must pay debt service whereas the other does not) as well as what kind of return each property will get (since the leveraged property has a much smaller percentage of the owner’s capital invested as a down payment).
For this reason, how we determine cap rates is by excluding debt service entirely. Instead, the cap rate compares what kind of return each property would have if it were unleveraged. This creates a like-to-like comparison.
How to calculate cap rate
The formula for how to calculate a cap rate is actually very simple:
Cap Rate = Net Operating Income / Total Cost of the Property
We’ll take each component separately:
Net Operating Income: The net operating income is calculated by taking the operating income of a property (rents, laundry income, pet fees, etc.) and then subtracting it by the operating expenses of a property (maintenance, taxes, insurance, etc.). The total will be your net operating income. In other words, it’s the annual profit a property will make.
And remember, debt service is not included in a property’s operating expenses.
Total Cost of the Property: This is simply the total cost of a property. It includes the purchase price, closing costs and any repairs necessary to get it performing. Some will just use the purchase price, but this is misleading if the property needs to be repositioned. If you already own the property and are just looking to value or refinance it, use its current market value.
What will come out is a percentage, something like 8.3%. This is referred to as an 8.3 cap rate.
Let’s say you are looking at a property that is listed for $250,000 and will require $50,000 in repairs. For simplicity’s sake, we will ignore soft costs such as closing costs in this example, although you should make sure to include them in any analysis.
The property has an operating revenue of $70,000 and operating expenses of $40,000. Here is how we would calculate the cap rate:
Then you divide the net operating income by the total cost.
0.10 is expressed as a cap rate of 10%.
How to use a cap rate
Once you have determined a property’s cap rate, you can then compare it to other similar property’s cap rates. The higher the cap rate, the higher the return will be.
But what is a good cap rate for real estate? Unfortunately, there’s no clear and obvious answer to that question. Just like prices of single-family homes will differ by the area, the average cap rates will differ by the area as well. A-class property (usually upper-end properties built in the last 10 to 20 years) will have a lower cap rate than C-class properties. If it’s a multifamily with a lot of Section-8 tenants will usually have a higher cap rate. Properties in worse areas will have higher cap rates, etc.
What you’ll find is that less desirable properties will have a higher cap rate than more desirable properties. What this means in the real world is that investors require a higher rate of return for less desirable properties than for more desirable properties, which is hardly surprising.
This means that you must compare properties that are nearby and of a similar quality and age. The cap rate is supposed to boil down two different buildings into one number; what rate of return will these properties bring an investor assuming there was no financing. If the properties aren’t similar, then the cap rate is useless.
What to watch out for with cap rates
Cap rates are very helpful, but there are a lot of pitfalls. First of all, just like with any sort of calculation, a cap rate is only as useful as the numbers you use to calculate them with. Always be careful with seller-provided pro formas (future projections of a property’s net operating income), which are almost always going to be more optimistic.
It’s always better to get the actual operating history of a property. Ask for as many statements as you can get, but at least a T-12 operating statement (the last 12 months). This statement should include the property’s income and expenses for that time period. This will give you a much more accurate picture of how the property has performed. Perhaps it has done poorly, but there is a good reason for it. For example, if there were major repairs done six months ago and the property has just gotten fully leased up whereas there was a lot of vacancy before, you should use the real data to construct your own pro forma instead of solely relying on what the seller tells you.
Furthermore, you should investigate the operating history carefully as there are several ways to hide costs. Here are two of the most common:
- Bad debts: If the seller is using accrual accounting, you want to make sure that all bad debts have been charged off. With accrual accounting, all rents that are owed are counted as income. If the rent hasn’t been paid, it becomes an “accounts receivable.” Once it becomes clear that the rent won’t be paid, the debt is “charged off.” However, if those bad debts haven’t been charged off, it will appear that the property is bringing in more income than it is.
- Incorrectly allocated capital expenses: All expenses on a property are categorized as either operating expenses (recurring expenses) or capital expenses (one-time expenses). Capital expenses do not go on the operating statement, instead, they just go on the balance sheet. If the previous owner decided to upgrade all the electrical services, that is obviously a one-time charge. But I’ve seen things like replacing the carpet on turnovers put down as capital expenses. You will routinely need to replace carpets though, so this should be seen as an operating expense. Make sure to investigate any capital expenses the seller has had to make sure they aren’t assigning operating expenses as capital expenses to make the operating history look better.
I always add a line item in my pro formas for “recurring capital expenses” when evaluating apartments. Each year, a few A/C’s and furnaces will go out, sooner or later the roof will need to replaced, etc. Banks ask for this too but call it a “replacement reserve.” These expenses will come every year, so I would definitely recommend including this item in your analysis.
Lastly, when comparing the property you are looking at to others, remember that you are not seeing the repairs that will be required on other sales. You are also not seeing any potential increase in rents that are possible if those properties are fixed up. For this reason, you should try to compare the subject property to properties that are fully performing and not in need of repairs. This is usually obvious when looking at the pictures and occupancy levels.
While there are many things to be aware of when calculating cap rates, they are essential to understand and in evaluating a potential property investment.