When I first started getting serious about real estate investing, “cap rate” was the first term I stumbled upon that I had to look up.
As a landlord and owner of small rental properties, I knew some of the basics at that point – terms like rental income, mortgage interest, and amortization. But because I’d only been involved in duplexes and fourplexes, I hadn’t run across commercial real estate cap rates before.
As I ventured into the world of multifamily real estate syndications, “cap rate” became part of my daily vernacular. When you go to real estate investing conferences or read blog posts about commercial real estate syndications, the term cap rate (or capitalization rate) is often thrown around here and there, as if everyone should know exactly what it means.
I’m here to tell you that it’s okay if you don’t know exactly what a capitalization rate is or what it’s used for.
Cap rates can be hard to understand, and an accurate cap rate calculation can be difficult to do. The good news though, is that if you’re a passive investor, you don’t need to do the hairy work of calculating cap rates.
You do, however, need to have a basic understanding of what a capitalization rate is, how it relates to the rate of return, and what it means for any property you invest in.
In this article, we’ll go over what a commercial real estate cap rate is, how it’s calculated, what it’s used for, how it relates to the purchase price and property value, as well as what you need to know about them if you’re a passive investor in a commercial real estate syndication.
What Are Cap Rates?
Cap rate is short for capitalization rate. It’s used in the world of commercial real estate to indicate the rate of return that a property is expected to generate. The cap rate is based on a ratio of the current income to the market value of the property.
Investors typically use cap rates to estimate their potential return on investment (ROI) for a particular asset. And generally, investors figure that a higher cap rate equals a better investment. While this can sometimes be the case, there is often much more nuance involved (more on this in a minute).
You might hear people say that a property has a cap rate of 5%, or that assets in a given area are trading around a 5-cap. Let’s talk a little about what this means, what this tells you about the value of the property in relation to the purchase price, and how people arrive at these numbers.
How Is Cap Rate Calculated?
Believe it or not, there are multiple ways to calculate a cap rate, so always be sure to ask how someone arrived at a particular cap rate.
The most popular way to calculate a cap rate is by taking the net operating income (NOI) and dividing it by the market value.
Let’s walk through a few examples so you get a better understanding of how all this relates to the overall value of a particular asset.
What Does A 7.5% Cap Rate Mean?
Let’s say we’re looking at a value-add commercial real estate investment property that’s priced at $1 million. Over the last year, let’s say that the property brought in $100,000 in gross income.
After paying $25,000 in expenses, the net operating income (NOI) comes out to $75,000.
Take that $75,000 net operating income and divide it by the $1,000,000 purchase price, and what do we get?
We get 0.075, which means that the cap rate for this particular property is 7.5%.
This means that if we were to buy this property for $1 million in cash right now, we could expect to get $75,000 in net income over the course of a year.
In loose terms, this is your ROI (return on investment), which speaks to the overall value of the investment.
Another way to think about this 7.5% cap rate is that it would take about 13.3 years of $75,000 per year to recoup your initial $1 million investment. For a property at a 5-cap, with the same $1M purchase price, it would take 20 years to recoup the initial investment.
What Is A Good Cap Rate For Commercial Real Estate?
Let’s take a look at another example. Let’s say that a different $1M value-add investment property were to generate $150,000 in gross income with, say, $50,000 in expenses.
The first thing we’d need to do is calculate the net operating income, which would be $100,000 (net operating income = gross income minus expenses).
In this case, the cap rate would be $100,000 / $1,000,000, or 10%. In this scenario, it would only take 10 years to recoup the initial $1 million investment. Thus, this property would theoretically be a better return on your investment than the property in the first example.
In general, a higher cap rate means you’re getting a better deal, because the investment is generating more income for the amount you’re investing into the property. A lower cap rate generally means that you’re paying more and getting lower returns.
So what is a good cap rate, you ask? The short answer is, it depends. It depends on the market you’re investing in, what other properties in that market are trading for, potential market growth, the property value vs. net operating income, potential cash flow, and more.
What’s good in one market might be very low in another market, so it’s important to evaluate several properties in your target market, to get a better handle on a typical rate of return vs. market value.
How Are Commercial Real Estate Cap Rates Used?
Some investors put a lot of weight into cap rates. They look exclusively for value-add properties that have a cap rate of 8% or higher, for example.
However, keep mind that a cap rate is just a single point of measure, and at one given point in time. They do not take into account leverage (i.e., any loans you’re taking out to purchase the property) or the time value of money (i.e., it assumes you’re getting all the returns at one point in time).
Comparing Different Properties In Your Target Market
Cap rates are most useful when comparing different properties in a given market. For example, let’s say that you are looking at an apartment building that is selling for a cap rate of 7% (or if you want to sound all slick, you can say that it’s trading at a 7-cap).
When looking at other comparable properties in the immediate market, you see one property with a cap rate of 6.7%, one property at 7.2%, and a third property at 7.5%. This tells you that the property you’re looking at is right in the middle and is thus fairly comparable to the returns and purchase prices of the other assets in the market.
If, on the other hand, you see that other properties in the market have cap rates around 4%, this should be a red flag. Why is the property you’re looking at selling for such a low price in comparison to the amount of income it can generate? Is there something wrong with the property? Or did the property owner do the math wrong?
An Indicator Of Potential Risk
Cap rates can also be a good general measure of the asset class and corresponding risk. Assets with higher cap rates tend to be in more developing areas and thus come with more risk. Assets with lower cap rates tend to be in more stable areas, often with greater demand, and thus can command higher prices.
That’s why you’ll often hear about cap rates compressing (i.e., getting lower) in a hot market like the San Francisco Bay Area. Because there’s so much demand, people are willing to pay higher prices in exchange for lower rates of return, thus driving the overall cap rates in that market down.
What Do You Need To Know About Cap Rates As A Passive Investor?
Okay, now that you’ve slogged through the full context of what cap rates are, how they’re calculated, and how they’re used, you want to know what you actually need to carry in your brain about them as you’re evaluating potential real estate syndication investments.
The short answer is, not much.
As a passive investor, there are many metrics and data points that are far more important when evaluating a potential investment opportunity, like the track record of the general partnership team.
As a passive investor, there are only two main things you need to know about cap rates.
#1 – Is the cap rate comparable to other assets in the area?
Any good sponsor team will have already made sure that the cap rate for the property you’re investing in is right in line with others in that market, but you can always double-check just to be sure.
You don’t want to be investing in a property with a 4% cap rate when all the others in that market are at 7% or higher, and vice versa. That could mean that there’s not enough value in the property.
#2 – What’s the reversion cap rate?
Okay, here’s a new term for you – reversion cap rate. Don’t worry, it sounds fancier than it is.
Sometimes the reversion cap rate is also referred to as the exit cap. That’s because the reversion cap rate is a measure of the cap rate at the exit, or sale, of the asset, as compared to the rate you go into the investment with.
If you get nothing else from this article, here’s the most important takeaway.
When evaluating a potential real estate syndication investment opportunity, be sure that the reversion cap rate is at least 0.5% HIGHER than the current going-in cap rate.
What this means is that the general partners are assuming that the conditions at the sale will be WORSE than the current conditions. In other words, they’re assuming that they won’t be able to sell the property for as high a price, when compared to the net income, at the time of the sale as compared to now.
If the current cap rate is 5.0%, you want to see that the reversion cap rate is at least 5.5%. That tells you that, even after the general partners do all the work of adding value to the property over the next few years, they are projecting a LOWER sales prices in comparison to the HIGHER net operating income.
This means that the underwriting is conservative and that the projected returns account for the possibility of the market softening a bit over the next few years.
All in all, you don’t need to remember too much from this article. In fact, I won’t be offended if you forget most of what you’ve read over the last few minutes.
Because at the end of the day, the capitalization rate is only a single measure, at a single point of time, based on the current performance of a given property. Cap rates fluctuate all the time, and they do not measure the future potential of an asset, nor do they tell you how much you’ll receive through your cash flow distribution checks.
As a passive investor, you should have a basic understanding of what a capitalization rate is and be on the lookout for the reversion cap rate when scrutinizing investment summary decks.
Beyond that, you can feel free to let the rest of the examples and figures in this article float into the ether, together with what you learned in high school geometry class and what you had for lunch last Tuesday.
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