Table of Contents
2. Defining Capitalization Rate
3. Formula for Determining Cap Rate
4. Calculating Cap Rate
5. Familiarizing Yourself with Cap Rates
6. Know Your Cap Rate when Listing a Property for Sale
7. Does Net Income Change the Value of the Property?
8. How Cap Rate & Interest Rates Work Together
9. What is a Good Cap Rate?
10. Use BAM Capital’s Cap Rate Calculator Instead of Doing It All on Paper
Real estate investors cannot jump blindly into the first investment property they see. They need to perform their due diligence and find out everything they can about a prospective investment to make sure it is going to be profitable for them.
Investors may use different metrics to determine which real estate properties would make the best investments. Capitalization rate, also known as cap rate, is one of the most popular among these metrics because it gives investors an idea of a property’s return potential and profitability.
An investment property’s cap rate represents the yield or income that a property will make over a year if the property was purchased on cash and not on loan. This shows a property’s natural rate of return.
Cap Rate Calculator for Real Estate Investing
If investors want to use cap rate as a metric for their next investment, they may use a cap rate calculator—such as BAM Capital’s very own cap rate calculator—to quickly get an idea for how much money a property could bring in.
Companies typically use cap rate to compare properties in the same area. A cap rate calculator is a very useful tool for making these quick estimations. But first, investors need to know all about cap rate and its uses.
Defining Capitalization Rate
Capitalization rate is the rate of return on a real estate investment property. It shows what part of the initial investment will return to the investor each year. If an investor purchased an apartment complex for $100,000 and the cap rate is at 10%, then this means 10% of the initial investment will return to them every year. Since the net cash flow will be zero after ten years, investors will begin to make money on this investment starting from the eleventh year. [1]In the world of real estate, it is used to indicate the expected rate of return on a particular investment property. Investors can use cap rate to estimate their potential return on investment (ROI). It is calculated by dividing the net operating income (NOI) by the property asset value. The result is then expressed as a percentage. [2]
Investors should keep in mind that cap rate should not be used as the sole indicator of a real estate property’s strength and potential. There are factors it does not take into consideration such as leverage, property improvements, and the time value of money. The best use for cap rate is for quickly comparing the value of similar properties in the market.
Formula for Determining Cap Rate
When it comes to the computation of cap rate, there are several versions of the formula. However, the most popular version involves calculating cap rate by dividing the property’s net operating income by its current market value. [2]
This formula is expressed as the following:
Capitalization Rate = Net Operating Income / Current Market Value
In this formula, the net operating income refers to the annual income that the property is expected to generate through rentals. NOI is determined by deducting all the expenses incurred for managing the property, including maintenance, repairs, and property taxes.
The asset’s current market value refers to the present-day value of the real estate property based on the current market rates. [2]
Another version of this formula uses the net operating income and the property’s original capital cost or purchase price. This formula is expressed as:
Capitalization Rate = Net Operating Income / Purchase Price
This version of the cap rate formula is not as widely used because it may create unrealistic results for older properties that were bought years or decades ago at lower prices. It also cannot be used on property that was inherited because this means their purchase price is zero. Not to mention that prices of properties tend to fluctuate widely. The first version of the formula is more accurate because it uses the current market price. [2]
Calculating Cap Rate
Some investors use the property value and then add other parameters like vacancy rate and operating expenses to paint a more accurate picture when calculating cap rate. Operating expenses include utilities, maintenance, and insurance, but not mortgage payments, income taxes, and depreciation. The net income refers to the cash earned before income tax and debt service. [1]
The following formula is used for net income:
Net income = (100 – operating expenses)[%] * (100 – vacancy Rate)[%] * Gross Income
To determine your net income, you have to determine the property value. Let’s say for example that your property value is at $200,000. Next, you have to determine the gross rental income. This refers to the amount of money you get from your tenants annually, for example: $30,000 per year.
Then you can factor in your vacancy rate, which refers to how long your units stay unoccupied—in this case let’s say it is at 2%. Determine your operating expenses: this is the amount you spend on keeping the property running. Some property owners spend $500 monthly to maintain their investment property. This is equal to $6,000 a year, which is 20% of your gross income.[1]
Following these example figures, the formula for your net income would be
Net Income = (100 – 20)% * (100 – 2)% * $30,000 = 0.8 * 0.98 * $30,000 = $23,520
Once you’ve figured out your net income, you can divide this figure by the property value to find your cap rate. In this example, your cap rate would be 11.76%.
Familiarizing Yourself with Cap Rates
Capitalization rate can be a very useful tool for investors, particularly when it comes to determining the best real estate property to invest in. An investor is more likely to profit from a property with a 10% cap rate compared to another one that has only 3%. This percentage tells you how long it will take to recover your initial investment so you can make money out of that piece of real estate. [3]
With different cap rates come different risk levels. This is something investors should take note of because while properties with higher cap rates may potentially be more profitable, they may also be riskier. Properties with a lower cap rate may represent a lower risk.
A property in a highly desirable location would have a lower cap rate due to the asset’s high market value. On the other hand, a property that is not well-located would come with a higher cap rate due to its lower market value. This means the ideal cap rate depends on an investor’s risk tolerance.
Investors should use their knowledge on cap rates and then consider other metrics to come up with the best possible decision on their real estate investment.
Know Your Cap Rate When Listing a Property for Sale
Aside from comparing investment properties, cap rates can also be used when selling a property. This works best for multifamily properties like apartment complexes because the formula uses annual net operating income. Cap rates may not be as useful for real estate investors looking to fix and flip properties or only planning to rent a unit for a short period of time. [4]
Whether you are selling your real estate property or looking into buying one, cap rate will help you assess the level of risk involved. Use it to evaluate commercial real estate, apartment buildings, townhouses, multifamily rental units, and even single-family rental homes. Cap rate is a key metric when it comes to evaluating any income-producing real estate property.
Does Net Income Change the Value of the Property?
Based on one of the formulas discussed above, investors can definitely use net income to calculate cap rates. If a property’s net income changes, this will definitely affect its value. This can happen due to changes in the local real estate market, for example.
If your property is in an area that is growing in popularity due to various economic or social factors, the demand for it will increase. As a result, you may be able to rent out your rooms with higher rents for a certain period of time. This will therefore increase your total net income, which then affects the property’s value. The higher the demand, the higher the prices. The property’s value will increase and this will impact its cap rate. [1]
How Cap Rates & Interest Rates Work Together
Cap rates and interest rates are closely linked. Interest rate is one of the most common external factors that affect a property’s cap rate. If interest rates are high, real estate properties become less attractive to investors and therefore less valuable. Some investors are no longer satisfied with a 10 percent rate of return. During a time of increased interest rates, investors may gravitate more towards other types of investments. [1]
If interest rates go down, then the property’s value increases and the cap rate goes down. The key takeaway here is that external factors can affect a property’s market value through cap rates even if the rental prices are not directly affected.
What is a Good Cap Rate?
This is a common question among real estate investors, but the truth is that there is no single answer to this. It largely depends on the investors’ risk tolerance. It also requires context: cap rates do not exist in a vacuum. You need to consider the market, the property’s location, and other factors.
If an investor is looking for a deal with a lower purchase price, then a higher cap rate may be ideal. Something between four and ten percent may be considered a “good” investment. A property with a higher cap rate is more likely to cover the cost of purchase quickly.4]
But aside from looking at “good” cap rates, investors should also consider the safety of each investment. Cap rates are used for risk evaluation, and so investors should use it to find safer investments. Some investors are comfortable with riskier investments while others are not. Those who are more risk-averse should go for properties with a lower cap rate because they are associated with lower risk. This will ultimately depend on your investment goals: never take on more risk than you are comfortable with.
Cap rates should never be your only basis for your investment decisions. They are good for quick comparisons, but if you are getting closer to choosing an investment property, you need to take a closer look using other metrics. Use cap rates to quickly identify properties that are worth checking out in more detail. This simple information may help you decide whether or not to buy a certain piece of multifamily real estate. [1]
While you can definitely calculate cap rates manually, it is much easier to use online tools such as BAM Capital’s very own cap rate calculator. All you have to do is put in the values and easily check the cap rates of various properties.
BAM Capital does more than just give you access to a handy cap rate calculator. This Indianapolis-based company actually gives you access to an even better way of investing in multifamily real estate. With BAM Capital, accredited investors can grow their wealth through syndication.
If you want to invest in multifamily real estate but don’t want to run an apartment complex yourself, talk to BAM Capital!
Multifamily real estate investing is known to be profitable. However, running your own apartment complex and being a landlord takes a lot of work. You need to handle emergencies, manage tenants, collect rent, remind people to pay rent, manage the property, and maintain an entire building to keep it in top condition. You have the option to hire a property management company, but this does not automatically make it a passive investment.
But through multifamily syndication, you get to enjoy all the benefits of multifamily real estate without the hassle of becoming a landlord. This is what a truly passive investment is like.
Syndication is when multiple investors pool their resources together to purchase a single property—usually something that is too expensive to purchase on your own. A syndicator, also known as a sponsor, puts the deal together and then looks for passive investors to participate in the syndication. Multifamily syndication is one of the most popular types because of its consistent and reliable cash flow.
BAM Capital will negotiate the purchasing and financing of high-quality multifamily properties in the Midwest, on behalf of its accredited investors. BAM Capital uses a vertical integration model that mitigates investor risk and creates forced appreciation. They prioritize Class A, A-, and B++ multifamily properties to minimize investor risk. [5]
Working with BAM Capital makes it easier to invest in multifamily real estate. This syndicator has a consistent track record and a solid business plan. In fact, BAM Capital currently has over $700 million AUM and 5,000+ units. You no longer have to look for an investment property by yourself.
Schedule a call with BAM Capital and invest today.
