The first thing all of us consider in determining a fair price for something we are buying or selling is to look at the prices of comparable items that have recently sold. If we are looking to buy a home to live in, we will first want to know the prices of similar homes that have recently sold in the area - and then consider other factors such as the property's amenities, overall suitability for our families, schools, etc.
When considering investments in income properties additional tools are needed to determine fair market value and "Cap Rate" is one of the most popular. Simply put, Cap Pate is the expected annual return on your investment, excluding the mortgage expenses. By eliminating mortgage costs, the Cap Rate provides a better apples-to-apples figure than can be used to compare income properties against each other when you are initially evaluating various property investment options.
A basic Cap Rate calculation is done as follows:
1. Determine expected gross annual income
2. Determine Net Operating Income by subtracting all anticipated property operating expenses e.g., management expenses, maintenance, insurance, real estate taxes, utilities, HOA dues, etc.
3. Divide the NOI by the property value to calculate the cap rate
As an example, let's assume that you own a rental property that is valued at $500,000 and it generates gross rental income of $3,000 per month or $36,000 per year. Annual operating expenses include:
$3,000 - Management expenses
$6,000 - Real estate taxes
$11,000 - Maintenance and other expenses
Total annual expenses are then equal to $20,000.
Net Operating Income is therefore equal to $36,000 of gross rent less $20,000 of total operating expenses or $16,000.
The Cap Rate for this property is the Net Operating Income of $16,000 divided by the $500,000 value of the property or 3.2%. Among investors, this is often referred to as "a 3.2 Cap property."
Cap Rates can be used to compare options for investors who are primarily seeking income. Typical Cap Rates range from as low as 3 for an attractive multifamily property in a high growth area to as high as a 10 (or more) for a property in a less desirable area or a property having greater risk of loss of future income. Since Cap Rates do not consider potential appreciation, patient investors who may be seeking higher total returns consisting of both income and appreciation over a longer time horizon e.g., 10 years, may be willing to invest in area with low cap rates and higher appreciation potential e.g., San Francisco Bay, Manhattan, Miami, etc. Many older investors however will tend to seek higher income properties in areas with higher cap rates and lower potential future appreciation - and begin selling highly appreciated properties in low cap rates to reinvest in higher cap rate areas to achieve greater income. Appreciation is nice - but it does not improve one's lifestyle unless converted to cash.
Investors also use Cap Rate comparisons as a tool for assessing the relative risks among assets in a similar asset class. As an example, when considering two Walgreen's drug stores in similar areas, it is likely that the Cap Rates will differ - and sometimes by a large amount. If you find one of the stores to be offered at a 4 Cap Rate and another at a 7 Cap Rate, what can you conclude? In general, the higher Cap Rate signals that there is likely more risk associated with property. For single tenant triple net (NNN) investments like a Walgreen's, the most common risk factor affecting Cap Rates is the remaining term on the lease. The 4 Cap Rate offering may have a full 15 years of term remaining on tis lease whereas the 7 Cap Rate offering may only have 4 years remaining thereby adding greater renewal risk to the investment.
Cap Rates are often confused with another often-used financial metric, Return-on-Investment or ROI. ROI can provide a more accurate measure of actual cash flow since it does factor in any financing costs. If two similar properties have the same Cap Rate, but one is more expensive to finance, the added financing costs will weaken the net income after debt service obligations for that property. Said otherwise, Cap Rate is the percentage an investor would make on their money if they paid cash for the property, and ROI is an investor's percentage return when financing costs are factored in.
Finally, most of our investors want to know the net cash-flow of potential investments after all expenses and all taxes are paid out (including personal income taxes). We believe that calculating net cash flow is ultimately the best way for income-oriented investors to compare options - however Cap Rates are a good starting point,
Cap Rates should only be used as an initial tool when comparing investments - and it is unwise to solely make investments based on them. Location, property condition, tenant quality, management, taxes, and many other factors should be considered when making income property investments.
Our team at First Guardian Group can help you wade through the various financial metrics and develop investment options that may be most suitable to meet your objectives. Please us at 866 398-1031 or send us an email at info@FirstGuardianGroup.com for more information.