The good folks over at Property Metrics wrote this very helpful blog post about capitalization rates in real estate investing. The post explains what cap rate is, how to calculate it, when investors should use it, as well as some alternatives that some investors use.
In my opinion, cap rate is one of the key metrics that real estate investors need to know about their properties — current properties as well as potential deals. Investors should memorize the simple calculation to determine cap rate so they can calculate it quickly (annual net operating income/cost of deal)
Admittedly, cap rate is a back-of-the-napkin type of of calculation and there are other factors that have the potential to impact the cap rate (such as a regular increase in annual net operating income or growing costs to maintain the property, etc.) But overall, this is a very servicable calculation.
There are three reasons why I really like the cap rate.
CAP RATES EXPRESS THE OPPORTUNITY (OR COST) OF RISK
I’ve been writing a lot about risk and risk management lately as I interact with Aswatch Damodaran’s excellent book Strategic Risk Taking. Cap rate fits right into the conversation of risk management because cap rates help you quantify the reward you get for the risk you take in real estate investing.
Many potential real estate investors scratch their head in wonder at how to determine whether or not a deal is worth doing. The cap rate, in spite of its flaws, helps to illuminate the answer. Investors can compare the cap rate of the real estate deal against the returns they can expect to get from other investments. In the article by Property Metrics, they give the example of someone who has $10 million to invest and they can invest their money in a property with a 5% cap rate or a 3 month T-Bill with a 3% yield (and is often called “the risk-free rate”). The difference between the two is 2%. That’s the return you get for the additional risk you’re taking over and above a T-Bill.
It doesn’t matter how much money you have to invest, the comparison is the same: Look at the amount of money you have to invest and compare your real estate investment options it to a T-Bill. The difference is the return percentage you hope to earn for the additional risk you’re taking on.
CAP RATES ENABLE YOU TO COMPARE ALL DEALS
When you are trying to decide if a deal is worth doing, or if you are trying to choose one deal from several potential deals, the cap rate can help you here as well. Cap rates reduce all of your deals down to one easy-to-compare number. So if you are looking at a commercial property or a bungalow or an apartment complex (which are 3 very different real estate investments), you can still easily compare them. Obviously this isn’t the only piece of information you’ll use to determine whether or not you want to do a deal but it’s a helpful piece of information.
CAP RATES HELP TO KEEP YOU ON TRACK
As the article indicates, cap rates viewed over a period of time can reveal trends. When you view cap rates for a particular market, you gain a glimpse of how that market is doing. When you view cap rates for your own deals, factoring in additional costs or changing values, you can determine how your own deals are doing. You can do this for individual properties, and you can do this for your entire portfolio of properties as well, gaining an aggregate view of the trend of your portfolio.
So get to know cap rates. Make them one of the numbers you pay attention to in your business and practice calculating cap rates so you can build up some confidence in understanding the numbers and using them.