The cap rate for investment properties is among the most crucial tools in the real investing world. And similar to most questions bothering the minds of many investors, this is a complicated subject without a straightforward and single manner.
Cap Rate – A Short Definition
Capitalization rate or simply cap rate is among the metrics most commonly used for measuring the profitability of real estate investment. This describes the rate of return of rental property no matter what the financing method is. Theoretically, cap rates are the measurement of risk level associated with an investment property. Lower cap rate means lower risk level, while higher cap rate corresponds to higher risk level. It is logical since the investment in low risk means low profitability and high risk means potentially big gains.
How is cap rate calculated?
The formula is very simple. You just divide the NOI or net operating income by the value or price of the property.
What is the Acceptable Cap Rate for Your Property?
Before anything else, the cap rate can differ according to the type of asset. For example, multifamily properties constantly have lowest cap rate since these are regarded to offer the lowest risk. This is because of a simple reason. Apartment buildings can generate rental income from several tenants monthly. It means that even one or two tenants failed to pay rent for a specific month that month’s change in cash flow is relatively small as well. On the other hand, imagine owning a luxurious and large house that you rent to just one family. When the tenant failed to pay their monthly rent, you will be left without any income. The risk here is higher.
Cap rate also differs in every market. As you have probably heard a lot of times, location is everything in real estate investment. Cities, neighborhoods, and states all have varied cap rates. It is partially since operating costs, acquisition costs, and rents change from one place to the next. These can also change after some time. Every market also exhibits varied supply and demand and this can cause some significant differences as well.
It means that even though cap rate can be used for comparing the profitability and risk of comparable properties in the similar market, you must never decide between purchasing a two-storey home in Miami or a small Boston apartment based on this alone. As the general rule, you have to set the average capitalization rate in the place you are considering as the minimum goal when buying an investment property.
The Bottom Line
Cap rate is a very helpful metric you can use when looking for a property and a market. But, make sure you don’t just base your financial decision about the property purchase solely on the cap rate. The major downfall of cap rate is that it doesn’t consider the depreciation or appreciation of rental properties that play a big role in identifying the return on the real estate investment you make.