What Cap Rate Means When Investing in Real Estate
Every investment is made with a purpose, which ultimately is making profits. Investing in Real Estate can be a little tricky when it comes to determining the actual profit from the investments. In Real Estate, Investors use various metrics like time, risks, expenses, location, etc. to determine the profit that can be made from their investment. One such important metric that Real Estate investors look into before investing is Capitalization rate, also known as cap rate.
Cap rate allows investors to compare different investment opportunities, choose the best property, and make decisions efficiently. If you are investing in Real Estate, calculating the cap rate before investing is what you might want to do to make better decisions.
What is Cap Rate?
The capitalization rate is calculated by dividing the property's net operating income by the asset’s current market value. The cap rate is the rate of the total profit that a property is expected to make based on the income it generates. For Real Estate investor's this is a very crucial metric to check for as it helps the investor to check the viability and quality of the investment. It is a simple, easy to calculate, and effective metric that helps the investors to make better decisions.
The formula applied for determining the Capitalization rate is the Net operating income of a property divided by its current market value.
- Net operating income - Net operating income is the total income calculated after deducting all the operational expenses like management fees, taxes, etc. except the mortgage.
- The current market value of the property - The assets value in the current Real Estate market.
Calculating the Capitalization Rate
Calculating this metric is quite simple, and anyone can do it using the simple formula. Every investor should calculate this metric before investing. Here's an example of the calculation and its usage.
Let's suppose there is a property worth Rs. 20,00,000 in the market. It generated an annual income of Rs. 2,00,000, and operating expenses accounted for Rs. 12,500. The net operating income of the property is obtained by subtracting the annual income with the operating costs, which is Rs. 1,85,000. The net operating income divided by the property's current market value gives the cap rate, which is 9.2% for this property.
Deductions From the Cap Rate
Increasing cap rates indicate that the property's market value is decreasing. Though it is assumed that, the higher, the better, it is not always true. Increasing, cap rate indicates a loss to the investor. A rate between 4 to 10% is usually considered to be ideal for investment in Real Estate. Hence the increasing cap rate is synonymous with higher risk as the property's value is going downhill.
Higher the cap, the higher the risk. A high cap rate, which is wrongly assumed to be profitable, is not reasonable to the investors in Real Estate. A higher cap rate though indicates high net operating income also is a warning sign for the decreasing or stagnant value of the property. This means that the property even if it is generating more rental income it's the market value, is not. This will ultimately lead to low profits as there is no capital appreciation. Investors should always look for a decent cap rate, not too high or not too low in Real Estate.
Locality Indications Example
Location is a significant factor for investors in Real Estate. Highly developed areas in major metropolitan cities usually offer a pretty decent cap rate of 4 or 5%; in contrast, the developing areas offer a 10% cap rate. This higher capitalization rate indicates a lower market price than the net operating income. In this scenario, the high cap rates demonstrate a relatively higher risk.
For instance, consider cities like Chennai, Hyderabad, or Delhi where the Real Estate is developing at a fast pace, here the cap rates range between 6-8 %. Investments in these cities are considered to be a relatively low risk than other cities.
Using Cap Rate for Real Estate Decisions
The capitalization rate is a very reliable metric that can be used for making better Real Estate investment decisions. Once an investment completes its maximum tenure, this will play an essential role in deciding whether to withhold the investment or let it go.
The capitalization rate is useful for any investor when he has an option to choose between two different investment opportunities.
Let's say there are two apartment units A and B in a locality worth Rs. 10,00,000 and Rs. 15,00,000 in the market.
Annual rental income from apartment A is Rs. 50000, and B is Rs. 120000. Operating expenses of these apartments A and B were Rs. 5000 and Rs. 12000.
When we calculate the capitalization rates of both the apartments, the cap rate of apartment A was 4.5%, and apartment B was 7.2%.
When the investor has an option to choose between these two options, apartment B is more beneficial. The rate of return is higher for apartment B, which will allow the investor to earn more profits than apartment A.
Fixing Income/ Rentals
In Real estate capitalization rate can also be used for fixing the rental for a property. If an owner is not sure about how much rental should be fixed for a property, he can gather information about the cap rate of similar properties in the same location. Using this metric as an indicator of similar property, the owner can fix/ decide the rental income for his property. This way, the capitalization rate is also used for making decisions related to the rental income.
When Selling and Buying
The capitalization rate is used by both the sellers and buyers. When sellers are looking to sell their property, they use this metric to obtain their property's current market value. Sellers will search for similar properties in the same location and find out the average cap value enquiring two or three similar properties. Then as the net operating of the seller's property is already known from the rental income earned and the expenses incurred, using the average rate of the locality as a reference, the seller can calculate the property's current market value.
Sellers always prefer low capitalization rates as it is more beneficial to them when the property valuation is high. Buyers also use this rate. The higher the cap rate, indicates higher the profits. The buyers should choose the properties with a 4-10 % cap rate. Buyers, before buying a Real estate property, need to look into the annual rentals and expenses. This information can be obtained from the seller, and the net operating income is obtained. Then dividing the net operating income with the property's current market value will give the cap rate. This way, the buyers can use capitalization rates for taking Real Estate investment decisions.
When Cap Rate is not Reliable
Though the capitalization rate is a highly reliable metric, it is not suggestible to consider it an ultimate measure for investing. It can be used as one of the parameters to choose the right investment but not the only one.
- The cap rate cannot be used when the asset's income is irregular, as this can mislead investors.
- The capitalization rate is irrelevant when purchasing land as the land is vacant and generates no income.
- Not useful when any loans are taken on the property or when the property is currently under improvements.
- Short term investors cannot rely on this rate as these properties do not generate regular income usually.
- The capitalization rate can also be skipped for Fix and flips as these are usually short-termed, and the investor's ultimate aim is to exit after a sale.
Cap rate is a useful metric that an investor can use for decision making. It can be used as one of the parameters for choosing a property, but not the ultimate one as, in some cases, it can be irrelevant. Real estate investment profitability can be estimated using many simple metrics and tools, and the cap rate is one of them. This metric leaves out many other factors like cash flows, valuation, etc. An investor should choose a property that is ideal for his objectives and risk-taking capacity.
Caprate between 4-10 % is said to be a good cap rate as it is not too low to generate good profits and not too high with the involvement of high-risk factors. 7.5% of cap rate is an ideal cap rate as it is within the 4-10% range.
A good cap rate is anything that is not too low or anything which is too high. A low cape rate indicates fewer profits and a high cap rate indicates a higher risk. So a cap rate of 4-10% is a good cap rate that yields good returns and is also not very risky.
An optimal cap rate which is not too high and not too low anywhere between 4-10% is a good cap rate.
Cap rate indicates the profits that investment is capable of producing in a time period of one year. The net operating income is divided by the property value to obtain a percentage that denotes its profitability.
The cap rate is not the same as ROI. ROI may change depending on different external factors like the method of financing used. Whereas the cap Rate remains the same in different circumstances of property unless there is change in the property value or the income from it changes. Cap rate gives a better understanding of a property.