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In the apartment investing industry, our return on investment, assuming we purchase the building in full with cash, is known as a capitalization rate, more commonly known as the cap rate.
Cap Rate Defined
A cap rate is a ratio that describes how long it will take to get back all your money in an investment. Pretty important, right? Let’s take a deeper dive and look at the various usages and reasons for why in some scenarios a low cap rate is good, and in others, one might prefer a higher cap rate.
In the apartment investing world, many would argue that the cap rate is just as important as the net operating income and even as important as the purchase price. In fact, that’s how you calculate it.
Understanding Cap Rates
A cap rate is simply the net operating income (NOI) of a property divided by its purchase price. For example, if the NOI of an apartment complex is $800,000 and the purchase price is $10 million, then the cap rate is $800,000/$10,000,000 which equals 8%.
Depending on your area, 8% could be good, but in other areas, it might be unrealistic. When analyzing an investment, the cap rate is a vital metric because it provides a portion of insight into the future. Cap rate is almost like an investor’s crystal ball to predict the upcoming years. Be mindful that this can deviate depending upon the economic cycle, fluctuations in NOI, property value, etc.
Another key concept to remember is that apartment complexes are not evaluated like houses. House values are based on “comps,” like-kind and quality nearby houses which have recently sold, whereas apartments are valued based on their profitability with respect to their investment (NOI divided by purchase price) — or in other words, the cap rate.
Cap Rate Comparison
The next most important analysis when looking at cap rates is knowing how to compare them and what gut instinct you should feel. A low cap rate (3%–5.5%) is likely to be found in a nicer area with better amenities, lower crime rates, better school systems, newer construction and typically A- or B-class properties. A medium cap rate (5.5%–8%) is usually found in a lower-income area with average amenities, slightly higher crime rates, average school systems, older construction and typically B- or C-class properties. A high cap rate (8% or highter) is usually found in a very low-income area with little to no amenities, high crime rates, poor school systems, outdated construction and typically C- or D-class properties.
To clarify, this largely varies when you change the geographic location. A 6% cap rate in Los Angeles is a completely different property than a 6% cap rate in a more rural town like Portsmouth, Virginia. When comparing cap rates, be sure to only make parallels to the cap rates of surrounding areas, because every city is different.
Which Cap Rate Is Better: High Or Low?
First, you must decide which type of return on investment you are searching for. Would you prefer a high monthly cash flow or long-term appreciation? There is typically a trade-off here. Most properties with strong monthly cash flow do not appreciate much over time. On the other hand, most properties with strong appreciation do not cash flow as much monthly. What is considered a high cap rate for the area typically produces a large cash flow monthly, but doesn’t appreciate over time. Whereas, a low cap rate typically doesn’t gush cash flow but has very strong appreciation.
Think of a trailer park as an example of a high cap rate. These will produce massive amounts of cash flow monthly, but unfortunately will not go up much in value over time. Now, think of Beverly Hills as an example of a low cap rate. This area will not cash flow much after the very high expenses; however, it will appreciate many times over with long periods of time used to your advantage.
Other Key Terms Relating To Cap Rate
Now that you understand cap rates, there are some key related terms that you should be aware of:
• Cap rate compression: Geographical, economic and market factors may push the cap rate lower in what is known as cap rate compression. This is typically indicative of rising prices in the market and potentially a perception of lower risk for that asset class.
• Re-capitalizing a deal: A capital restructuring of a company’s mixture of debt and equity that is usually performed, in most scenarios, to make a company more stable.
• Reversion (or exit) cap rate: The expected/projected cap rate at the time of sale in the future, which helps with financial projections and analysis when buying the property.
Re-Cap On The Cap Rate
Capitalization rate (or, more commonly, cap rate) is the ratio describing the net operating income with respect to its purchase price. Keep in mind, cap rates are strongly influenced based upon a property’s geographic location and the economic cycle. Use it as a quick snapshot to give you a pulse of the property before taking a deeper dive into the rent roll and the last 12 months of expenses. This will give you an overview of how the property performs and how long it will take to return the full investment when purchased in full with cash. Safe investing — now go capitalize!