What is a Cap Rate?
Simply put, a Capitalization Rate, or Cap Rate for short, is the return on an investment when you divide the Net Operating Income (NOI) by the price you are paying for the property. For example, if you purchased a property for $2 million dollars and produced an NOI of $100,000 annually, it would be considered a 5 percent cap rate.
Net operating income (NOI) is simply the annual income generated by an income-producing property after taking into account income collected from operations and deducting all expenses incurred from operations. These expenses include property taxes, utilities, repairs, maintenance, and property management fees. They do not include debt service, since some owners may pay all cash, while others take advantage of low interest rates and maximize the loan on the property.
What Does a Cap Rate Mean?
Cap rates are often used to compare similar properties that could not be valued using the traditional “Comps” of residential real estate. For example, if I’m looking to buy a home in a specific neighborhood and I’m considering two houses, I can quickly understand the value of the home by seeing what similar sized homes in that neighborhood have recently sold for, and adjusting for things like pools, the age of the home, etc.
However, when evaluating an investment asset, it can be substantially harder to find similar properties and assign a quantitative number to their differences. And since what one is really buying is a future stream of rental cash flows, not a residence to live in, it is necessary to underwrite the expected Yield on the investment. Cap Rates are one measure of investment yield.
A cap rate, as a measure of return, is far more valuable to an investor who may be analyzing two different apartment complexes on different sides of town. By researching the properties’ NOI and dividing by their purchase prices, it is easier to choose which may prove to be the better investment.
Generally speaking, the more desirable and less risky a property, the lower the cap rate and therefore the higher the price relative to the NOI. Today, an apartment near the beach may sell for a 4% cap rate, while properties in secondary markets where the perceived risk is higher will sell for higher cap rates and therefore lower prices.
Cap Rate as a Means to Add Value
One thing we specialize in at MV Properties is identifying ways to add value for our clients and their real estate assets. Most people do not think of cap rates in this manner, but here is an example:
We recently added a laundry room to a property that did not have any laundry facilities. The total cost of the addition and the coin operated washer and dryer was $15,000.
We were then able to raise rent on all five units by $200 per month – the desirability of the property went up and so the tenants were willing to pay a lot more. Who wants to spend their weekend at a laundromat?
We also collect approximately $200 per month in laundry income.
The total addition to the property’s Net Operating Income is $1,200 per month or $14,400 per year. The addition pays for itself in just about one year!
But even more importantly, that $15,000 addition just added $288,000 in value to the property!
Assuming a 5% cap rate of $14,400 / 5% = $288,000.
That’s a 19.2X multiple on the invested capital!
This is not a subjective valuation like a sales comp – it is the quantitative method appraisers and buyers use to value rental properties.
How Does My Property Compare?
At MV Properties, we are experts at Maximizing our clients’ cash flow, and preserving and enhancing the long-term value of their real estate assets. The large multiplier effect of cap rates means that it is imperative you maximize your Net Operating Income! To get a free benchmark report to see how your property measures up, contact us today!