Do you want to know how you can find the best real estate investments? Investing in real estate opens up a world of questions. Different questions for different types of property. When it comes to investing in rental properties the most widely asked question is about cap rate. What is cap rate? Cap rate stands for capitalization rate and is the rate of return you can expect on a real estate investment property based on the income the rental property is expected to generate. Read on to find out how you can make the best real estate investments using the cap rate.
How to Calculate Cap Rate
You can calculate the cap rate by dividing the income property’s net operating income (NOI) by the current market value or cost of the property. The NOI is the cash flow realized from rental income or any other source of income minus operating expenses. You want the net operating income to be a positive cash flow. This is achieved when the income received is greater than the operating expenses of the investment property. How to calculate cap rate:
Capitalization rate= NOI/market value or cost
For example, if you’re considering an investment property that costs $1 million and it is expected to generate a positive cash flow (after all operating expenses have been deducted) of $65,000 a year, then the calculation is as follows:
65,000/1,000,000= 0.065 or a percentage of 6.5%
It is important to note that a higher NOI doesn’t necessarily mean the property you’re looking at is more profitable. The condition of the property i.e. its market value could be quite low. This means that even though there’s a high expected net operating income, that cash flow might not even be realized because of the higher operating expenses required to maintain the property’s value. In order for a real estate investment to remain profitable, NOI must increase at the same rate as the value increases, or at an even greater rate.
Understanding Cap Rate
What’s a good cap rate? The answer to that question isn’t quite that simple. Usually, different cap rates represent different levels of risk between investment properties. Lower cap rates correspond to lower risk. Higher cap rates correspond to higher risk. So in reality, the question isn’t “What’s a good cap rate?”, but “what is the right cap rate given the level of risk?” We know that when it comes to any investment, higher risk= higher return, which makes sense. Making money in real estate follows the same rule. You wouldn’t invest in something risky unless you were expecting to make money off of it.
A real estate investor needs to make this decision based on the trade-off between the riskiness of an investment property and its cap rate. When it comes to buying an investment property, you’re going to be comparing multiple properties to make sure you’re choosing the right one. Any professional real estate investor knows not to just rely on one factor when it comes to making this decision. However, the cap rate could be a great indicator of a profitable property when it comes to comparing expenses and returns. Although cap rate is a great way to make comparisons of similar properties, many different factors need to be considered before making a decision to buy.
Effects of Different Factors on the Cap Rate
We gave you the basic formula for finding the capitalization rate. However, in the real world, it could be a bit difficult to include all the right expenses and make the right calculations. To find the right cap rate to use in comparisons, visit Mashvisor and use the best cap rate calculator out there. You’ll be able to analyze different properties from different neighborhoods and cities quickly and easily. To start using Mashvisor, click here.
To understand what the right cap rate is, you need to consider the factors that affect the cap rate.
Location
The property’s location, whether it’s a city or a neighborhood, is one of the most important factors. You’ve probably heard this point many times before in real estate investing. This is because location is what drives demand. Higher demand for a property in a certain area drives prices up. This increase in prices affects the market value or property cost portion of the capitalization rate formula. A higher price could decrease the rate leading you to assume that this isn’t a profitable property, even though it probably is. So know your locations and understand the effects it makes on the capitalization rate before making an investment decision.
Asset Type
We’ve already mentioned that different types of properties have an effect on the cap rate. In real estate investing you have the option of choosing multifamily, office, retail, hotel, industrial, etc. Most real estate investors go for multifamily properties because they are perceived to have a lower risk.
Interest Rate
Sometimes in real estate cap rates can shift without there being any change in NOI or market value of that property. This is due to the complex relationship between capitalization rate and interest rate. If the Federal Reserve adjusts interest rates this could lead to a shift of 0.5%-1% in cap rate. When interest rates rise, debt rises and your net cash flow decreases. So even though you don’t have much control over interest rates, you should be aware of them and their effect.
Conclusion
Every real estate investor wants to invest in the most profitable investment properties. That’s obvious. What isn’t so obvious is how. It could be difficult to choose which property is better than the other. Especially when they share similarities in things like location and type of asset. That’s why comparing cap rates of these properties could be what helps you make that decision. Don’t forget to check our cap rate calculator! To learn about your options for signing up for our services, click here.