Do you know what you need to know about cap rates? Many investors gravitate toward real estate syndications or passive investing after dabbling in the residential real estate space and realizing there’s a massive opportunity to earn great returns without being a landlord. The transition from residential to commercial real estate investments is accompanied by an overwhelming number of new and more complicated terms and calculations.
You may have heard about 8-caps, fully-spelled-out capitalization rates, and cap rates from others. While said different ways, these all mean the same thing and you may find yourself wondering if you know all that you need to know about cap rates.
As you move further toward passive investing, you’ll likely want to increase your confidence in evaluating slide decks for each potential investment opportunity. To do that, you’ll need to expand your vocabulary, become comfortable with terms, review past and present deals, and learn how uncomplicated investing passively in real estate can be.
In the blink of an eye, “cap rate” will be part of your daily conversations, and not only will you know exactly what it means, you’ll know when and why it’s important too!
It’s okay if cap rates are hard to understand or challenging to calculate. As a passive investor, you can inhale a deep calming breath because you won’t need to calculate or use them very often.
In this article, you’ll learn what cap rates are, how they’re calculated, when you’ll want or need to use them, and what they reveal about an investment opportunity. You’ll want a certain level of comfort with cap rates and, by reading this article, you’ll learn how they apply to your situation.
Cap Rates Defined
A ratio of the property’s income against the property’s market value gives you the capitalization rate, or cap rate for short. Cap rates are used in commercial real estate to measure the expected rate of return generated by an investment property.
No matter whether we’re talking stocks or real estate, it’s assumed that a higher cap rate equals a better ROI (return on investment), which would theoretically equal a better investment choice, which is why most investors are highly interested in their potential ROI.
As a passive investor in commercial/multifamily real estate syndications, you just need to know how to calculate it for yourself and have clarity as to how the cap rate pertains to your financial and investment goals.
Commercial Real Estate Cap Rate Calculations Simplified
Anytime cap rates are being discussed, make sure you ask how they calculated the cap rate. You want to make sure you’re comparing apples to apples, and you’d be surprised at the number of various ways people calculate cap rate.
Cap Rate = Net Operating Income / Property Market Value
Net operating income, or NOI for short, divided by the property’s market value is the most popular way to calculate the cap rate.
A 7% Cap Rate Example And What It Means
Pretend that we’re looking at a value-add multifamily complex priced at $1 million that brought in $100,000 in gross income over the past year. Let’s also pretend that expenses for the year on this property were $30,000, leaving the NOI at $70,000.
We take $70,000 (NOI) and divide that by the $1 million (market value) and arrive at 0.07.
This means the cap rate for this property is 7%, and if we were to buy this property for cash right now, we could expect to earn $70,000 in net income over the next year.
So, in general, this is your return on investment (ROI), and although it shouldn’t be the only metric you review, it’s an indication of how profitable your investment may be.
Now let’s look at cap rates from a slightly different angle:
A 7% cap rate means it would take approximately 14 years to recoup your $1 million in capital initially invested in the example above. A 6% cap rate on that same $1 million investment would require about 16 1/2 years to recoup your investment, and an 8% cap rate would take about 12 1/2 years. This helps illustrate the importance of cap rates and how they affect your ROI.
What Kind Of Cap Rate Should You Look For?
If you’re all about cash flow, a higher cap rate may seem more attractive.
Higher cap rates mean you’re getting more income for lower initial investment, and you’ll recoup your capital invested within a shorter timeframe.
A lower cap rate means your investment is higher, and the returns are lower. It will take more time to recoup your initial investment, but if you’re exploring more of a buy-and-hold strategy, it’s possible to come out better in the long term.
So, what’s a “good” cap rate for commercial real estate investments, then?
There’s not actually a straight-forward answer here. It really depends.
What’s good in one market may not fly in another. There are a lot of variables to consider like: potential market growth, other properties’ cap rates in that same market, the property value versus net operating income, if property expenses can be reduced as part of a value-add deal, your desired cash flow, and more.
I highly suggest evaluating multiple deals in a specific market to get the best apples-to-apples comparison.
How Should Commercial Real Estate Cap Rates Be Used?
Since the cap rate is only a single measurement taken at a single point in time, relying heavily on cap rates isn’t really a great strategy.
Some investors look exclusively for deals with 8% cap rates or higher, but considering cap rates are based on today’s market value and NOI and don’t consider leverage or time value of money, there are definitely other, more defining metrics that should be given attention instead.
Compare Properties Across Your Target Market Using Cap Rates
The best way to put a cap rate comparison to use is when looking at several properties in a particular target market. Let’s assume you’ve decided Jacksonville, FL is your target market for a value-add apartment complex. Then, ideally, you could compare a few properties within that market.
If you see one with a 6.8% cap rate, another at 7%, and another at 7.3%, you know that all three are pretty comparable. You could confidently dive deeper into the 7% deal knowing you’re right on track with returns and purchase prices of other properties in that same area.
On the other hand, if you discover a wide discrepancy between cap rates on similar properties in the same market, that could be a red flag. I’d recommend diving into the deals’ metrics deeper, find out how the cap rates were calculated on these properties, if there’s anything wrong with the property, or if the property is somehow being valued incorrectly.
Potential Risk Can Be Indicated By The Cap Rate
You can also use the average cap rate of a market to measure an asset class’s risk. Higher cap rate properties tend to be riskier and located in developing areas, while properties with lower cap rates are generally less risky and located in more stable regions.
If you’ve ever heard about cap rates compressing, all that means is the cap rate is decreasing in response to higher property prices and lower rates of return. This is common in places like California, for example, where the demand is high, so people are willing to pay more to snag a property even if returns are a bit lower.
Why Should Passive Investors Care About Cap Rates?
Now that you’ve seen how to calculate the cap rate, learned what a cap rate even is, seen a few examples, and now have a firm grip on how you could use cap rates to compare properties within a target market, what should really matter to you as a passive investor in regards to cap rates?
Sorry to break it to you, but cap rate specifics aren’t going to change your life.
There are many more important numbers and metrics that will make a bigger impact on your investment game! When it comes to vetting a potential investment opportunity, you’ll likely want to pay more attention to: the overall market in which you’re looking to invest in, the distributions to investors and make sure they support your investing goals, and the experience and integrity of the sponsor team.
Only two things regarding cap rates should matter to you:
1 – Is the cap rate comparable to other assets in the area?
You’ll know you’re working with a great sponsor team when you see they’ve already ensured the cap rate for the property in which you’re investing is in alignment with comparable properties in the same target market. Sure, it’s safest to double-check a few numbers, but that’s about all you need to do.
2 – What’s the reversion cap rate?
Wait. What?! Right when you start to feel like you’ve got this cap rate thing down, I throw in something else. Yep. Just trying to keep you on your toes 😉 Stick with me though; It’s simple.
The reversion rate (also called the exit cap) is the cap rate at the sale of the asset. This varies from the cap rate at the time of purchase.
And here’s the most important detail out of this entire article…Ready?!
When considering a commercial real estate opportunity, you want the reversion cap rate to be a minimum of 0.5% higher than the cap rate at which you invest or buy the property.
Before you invest, you want to see that the GP’s (General Partners) are assuming the market conditions at the sale will be less favorable than the current market. You want to invest in a property with conservative underwriting which plans for the possibility that the asset might sell for a lower price when compared to the net income, 3 – 5 years into the future.
I realize this may be counterintuitive. But let’s look at an example to walk this out.
If the current cap rate on your real estate investment opportunity is 7%, you want to make sure the exit cap (or reversion rate) is 7.5%. So, even after all renovations are made, efficiencies are increased, the occupancy rate is high, and rents are raised, you want the sponsors to expect a lower sales price compared to the higher net operating income (NOI).
Remember, even though you are planning for the exit cap, or reversion rate, to be less favorable at the time of sale or refinance, the investor team has maximized efficiencies and increased the NOI. So, the investment will still be valued higher than at purchase. All of this just plays into conservative underwriting, which protects your investment.
No one knows what the market will look like in the future, so projecting that it will be a little softer at that time is much safer than not. And, if it’s not, then it’s just gravy on an already profitable train you are riding.
What Do Cap Rates Ultimately Mean for Passive Investors?
In general, as long as you have a general understanding of what you have read here, that will be enough as a passive investor. Remember, as a passive investor, you are leaving the heavy lifting and massive number crunching to the operators.
A cap rate is just a single metric pulled based on the current value of the property. The rate will be different in 6 months or a year, and drastically different a few years from now. Knowing all the ins and outs of cap rates doesn’t help you project the potential of your investment or help you calculate the cash flow you may receive.
All you need is a fundamental understanding of cap rates and be aware of the reversion rate when exploring a potential real estate syndication investment opportunity.
Want To Learn More?
If there’s anything I’ve learned in my real estate journey, it’s that there’s always more to learn. So if you’re ready for a deeper dive into metrics that DO matter and you’re interested in comparing deals alongside me, Ohana Investment Partners is here to show you the way.
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