The CAP RATE (or Capitalization Rate) is mostly used in commercial real estate. It is used to measure the return of a property investment if paid in an all-cash purchase and is very easy to calculate. For instance, a property worth $300.000 that brings in, after expenses, 30.000 $ a year, has a CAP rate of 10%, another property worth $300.000 that brings in, after expenses, 15.000 $ a year, has a CAP rate of $15,000/$300,000 = 0.05= 5%
If you have 2 properties both valued at $200k the first one bringing in $1100 a month, the second bringing in $1300 a month the second has the highest CAP RATE. So, all things being equal, the higher the better.
Many commercial listings publish the cap rate of the property but how do you calculate the CAP RATE from a residential property on the MLS?
Normally CAP Rate is not directly connected with residential properties. If you buy a home for yourself you do not look at the CAP rate but CAP rate is a measurement very important when you buy for investment or if you but commercial real estate.
For the next exercise, I choose a townhouse in Silver Spring
The asking price is $230,000 – let’s assume we make a cash offer for $210,000 and the seller takes it.
The first thing we want is to calculate the NOI or Net Operating Income to see how much money we will cash in a year after expenses. First, we have to find out what this property would rent for and after a search on the MLS, I found that $2000 is a reasonable monthly rent. There is also a $300 condo fee to be considered. So we go with the following approximations:
So the CAP RATE IS = $12,322/$280,000 or the CAP RATE is about 4.5%
How do we analyze this? Is it good? Bad?
For residential property, it is not that bad. The average Cap Rate for all types of rental in the US is about 5% to 7% and that includes a lot of commercial properties. There is another thing in favor of the townhouse above. Real Estate makes money also in appreciation and the average appreciation of residential housing in the US is about 3% a year so the property above will make a combined return of about 7.5% per year. ( And it is a pretty safe return. The market plunged once last decade and we do not foresee another plunge in the near future but a steady appreciation. Right now, however. due to the Covid-19 the future is not so certain anymore. But it is because of Covid-19 that now it makes more sense to introduce a CAP rate to residential properties.
Is the above 5% capitalization rate the best we can do in the DC / Maryland area? Of course, we can get a better Capitalization rate just by changing the geographic area within Maryland. Baltimore provides a much higher average cap rate but a higher cap rate means also a higher vacancy in the area and maybe a high number of foreclosed property in the area and a low homeownership rate.
Basically, the Capitalization rate is higher in an area that is perceived with more risk. It is up to the investor to figure out what is the best return for the associated risk. Like for Capital Markets, more risk should be associate with more rewards.
Cap Rate in Commercial Real Estate
Let’s assume you buy a Commercial property for $400.000
Let’s assume we have vacancies this time 5% of the time.
Vacancy allowance = GOI * 5%
$4500=$90000 * 5%
$90.000 (GOI: Gross Operating Income, probably from rent. Quite optimistic but this is only for demonstration )
Appraisers might use Market Rate CAP rate to value a property based on returns. An appraiser would look at similar properties in the area. Market CAP rate is the average CAP Rate of similar properties sold in that market.
To have an example if a property Rents for 200,000 and has operating expenses of 120,000
NOI = 80,000 if the cap rate for the area is 7 ( a common cap rate in the Maryland area for commercial properties ) . the value range of the property would be
$80,000/ 7% = $1,1142,857
Basically, the Capitalization rate is higher in areas where that are perceived with more risk and it is higher for properties that present more risk because outdated etc. An A property will have a lower CAP rate than a C property. It is up to the investor to figure out what is the best return for the associated risk
Lower Risk : United States Treasury Bonds: very low rate of return
Low-risk properties: Lower CAP rate, usually in well-stabilized areas, usually Class A / B properties, lower returns
Higher Risk: Higher CAP rate, usually, is in the Not stabilized area ( but they could be in up and coming areas ), C properties, higher returns on the investment
CAP Rate is also influenced by interest rates. I just checked some graphs and the cap rate was higher 20 years ago. Why? Well, interest rates were a lot higher. Would it make sense to purchase a property with 9% interest rate if the CAP return is only 5% ? Probably not. So when interest rates were higher investors were mostly looking for a property where they could somehow pay the higher interest rate. But the fair yield for a real estate property can change during its life, and so can do its price. The Yield is basically the cash flow of the property. The cash flow and the NOI are different: NOT does include Cap Ex ( Capital Expenditures ) . CapEx espenses could be very high.
So the yield should basically compensate you for two things:
A loss of purchasing power or an opportunity cost as your money is tight up for quite a while, and the risk that you don’t get all the money back.
CAP Rate at Exit: This is valid for commercial properties. If your property reached a stabilized NOI we can calculate an approximate value of the property by knowing the Cap Rate for similar properties in the area and applying it to our property.
An Investor might have a different CAP rate need than the market cap rate.
CapEx vs Operating Expenses:
Operating expenses are the day-to-day expenses necessary to maintain the property. Operating expenses are deducted when they occur. Capital expenses are expenses that will extend the useful life of the property. Capital expenses are for example improvement deducted over the expected life of the improvement. CapEx can have a significant impact on the NOI.
CAP RATE at selling time: Well when you want to estimate the selling price of a renovated property we need to know the Cap Rate of the area. If we are the seller of course the lower the Cap rate in the area the better for us.
Why do we use CAP RATE? Because it is very simple to use and gives an immediate idea. It has limitations however, it does not consider the cost of time for restructuring ( if it takes 2 months you have a 2-month vacancy), changing expenses down the line (For example a new siding two years from now will set you back a lot of $$$ but it was not in this year OE ) – It also ignores CapEx and appreciation. So use Cap Rate only as a first way to screen investments
CAP rate is usually different for different types of commercial properties. Why is that? Well some properties are more risky than others so more risk usually goes with more reward