Capitalization Rate (CAP)
How risky is this investment? How long does it take to recover the initial investment in the property?
In this article:
- using capitalization rate as a riskiness indicator
- types of CAP and when to apply them
- CAP calculation formulas
- variables affecting CAP
- good/bad CAP myth
- SWORP TIP!
Do you like rates? This one is worth your attention. Easy to calculate, useful for a variety of property investment opportunities. Also, set in a proper context, it is a simple tool to identify which one of two very similar properties is worth your investment. The cap rate is determined based on the potential revenue and the riskiness of investment compared to other properties. It indicates an estimation of how long it will take to recover the initial investment in the property.
There are two kinds of cap rates. The first (CAP1) one is calculated as the net operating income of a given property (NOI) divided by the current market value of the property. This type is more popular amongst investors because it indicates how long it would probably take for the investment to return as an income generated by the property. Investors apply the CAP aspect when considering a variety of similar properties of the same market.
The second type (CAP2), which is not that widely used, applies the total purchase price instead of the current market value. If you already have similar properties of the same market in your portfolio, you can use this type of CAP formula to compare them and evaluate which one is, for example, worth selling. Be careful with this type, because the rate you get might be very inaccurate in the case of old properties (value of money in time is not projected to CAP), let alone inherited property because its purchase price is zero.
So far so good? Let’s walk through the formula on the example of CAP 1:
Take the property’s net operating income (NOI) and divide it by its current market value.
CAP1 = Net Operating Income / Current Market Value
For the reminder, NOI is the sum of the property’s incomes (rents, amenities) pruned by the sum of the property’s expenses (insurance, maintenance). Envision a property that generates 180 000 CZK per month in rental income plus 1 000 CZK in laundry machine fees. Your total income from the property is 181000 CZK. For expenses, we add up repairs, insurance, and vacancy rate (average assumption is 10%), which is in total, let’s say 45 000 CZK. This property’s NOI is 136 000 CZK per month. Given that all incomes and expenses are at the same level for other months as well, NOI would be 1 632 000 CZK per year.
The second step is calculating the total purchase price of the property which includes not only the cost of the property but also the amount you paid for reconstruction and repairs. Our imagined property’s current value is 106 200 000 CZK. Now we divide.
1 632 000 / 106 200 000 = 0,01
CAP is usually represented by a percentage, so let’s convert the product of division into a percentage. Multiply 0,01 by 100 to get a cap rate of 1%.
This result tells us that such investment is relatively not-that-risky, because the cap rate is low, and we can estimate that this property brings back 1% of the market value annually.
For your reference, try also CAP2:
CAP2 = Net Operating Income / Total Purchase Price
Which factors impact cap rate?
As a tool for evaluating properties, CAP should be a major player in your investment decision. However, it is as important to realize that there are many factors that noticeably impact the CAP.
Let’s walk through a few of them:
- The property’s location defines the height of CAP big time. A not-so-great location usually means a higher cap rate. Higher doesn’t mean worse, but riskier.
- Competitive market size also plays its role. A fierce competition of large markets results in lower CAPs compared to small, therefore riskier markets.
- Everything that impacts net operating income (NOI), projects into CAP directly. For example, profit loss caused by vacancy or costly repairs.
And we could go on and on. It seems that it takes a clairvoyant to see reality beyond numbers. Before you turn to the Oracle of Delphi, let SWORP give you a hint. There are situations where applying CAP to evaluate a property is necessary, but others where CAP shouldn’t be applied whatsoever.
CAP is useful when comparing the risk involved in multiple commercial and multifamily properties where you seek long-term cash flow. If your intention with the property is to flip as soon as possible, determining according to the cap rate doesn’t make sense. Also, if the property is “complicated” in a way that it generates irregular income, CAP is not useful, so you should apply other metrics to evaluate it.
The good/bad CAP myth
As tempting as it sounds, seeking out a universal cap rate that will solve all your investment dilemmas at once with just one glimpse at it, belongs to the realm of dreams utterly. CAP is intrinsically individual for each property and you certainly cannot use one property’s CAP to compare with other properties of different purposes, locations, and markets. Instead, use this tool to examine the level of risk you are willing to take when deciding on an investment.
In general, a higher cap rate accompanies properties that have high NOI and low total purchase prices. On the flip side, a lower cap rate characterizes properties with low NOI and high total purchase price. Lower CAP is typically perceived as less risky, but on the other hand, it typically takes longer to compensate for the initial investment. You as an investor decide what is an acceptable CAP for a property in your portfolio accordingly to your intentions with such property. Keeping it for cash flow? Flipping it immediately after purchase?
CAP could hands-down help you identify a good deal because it provides you with valuable insight into a property. Still, beware of using CAP as the only metric you consider when evaluating properties. Don’t forget to look at a cap rate from the perspective of other factors such as location and market size and compare similar properties. As you venture into property investment, you’ll see the effort invested in self-education paid off big-time.