Updated: Aug 13, 2020
When you first decide to start looking into real estate as a way to invest your hard-earned money, there are certain words that you will see and hear everywhere but might not recognize at first.
Things such as NOI, cap rate, LTV, triple net (or NNN), modified gross, escalation, or front foot just to name a few.
My goal is to demystify all of these terms for you so that when you are ready to make the jump into real estate, you are well-prepared and have all of the knowledge and information that you need to make an informed decision.
The term I would like to tackle here today is “cap rate”. One of the most heard phrases in investment real estate, it is simply an abbreviated way of saying “capitalization rate”. From here forward we will simply refer to it as “cap rate”.
So now that we know what it’s short for, let’s dig a little deeper into what it actually means.
A cap rate is nothing more than a way to compare investments’ performance and risk, regardless of condition, type, or price.
A very common misconception is that you want the highest cap rate possible. Where this can be a slippery slope is when you look at the correlation between cap rate and risk of the investment.
The higher the cap rate, the higher the risk of the investment. The lower the cap rate, the lower the risk of the investment.
Typically, a class A office building with fully-leased spaces to long-term tenants would sell at a low cap rate because it is a safe play with little risk that something is going to go wrong and money will not be made.
Conversely, a distressed multifamily property with a high vacancy rate, poor management, and outdated units is more likely to trade at a much higher cap rate simply because it involves much more risk.
The potential to lose your invested capital is higher, but so is the chance to make much higher returns on your investment if decisions are made wisely to add value to the property where it makes the most difference.
Let’s break down how the cap rate is calculated, then we will delve into the above examples to see what we might see for prices on the two respective properties.
The cap rate is a function of both purchase price and net operating income (NOI), so as long as we have two of the three pieces of the puzzle, we can find the other. The formula for calculating the cap rate is r = NOI / V.
Alternatively stated as Net Operating Income divided by the Purchase Price.
See how this would play out with the examples we used above for the office building and multifamily property where we know the net operating income and purchase prices for both properties.
This will show us what the cap rates are and how the risk and ability of each to convert income to value.
As you can see, finding the cap rate of the two properties is a great way to compare the two and get a better idea of which best fits your investment criteria regardless of the fact that they are in different price ranges.
Something we will discuss in more detail in the future is going-in and going-out cap rates on investments.
Matt Moreland, Realtor® is a real estate agent serving the Lubbock, Texas, and the South Plains. After graduating with a Bachelor of Business Administration in Finance with a concentration in real estate from Texas Tech University, he began practicing real estate full time at McDougal Realtors in Lubbock, Texas. Matt enjoys spending time with his wife and their dog. Some of his hobbies include investing in real estate, elk hunting, backpacking, barbecuing, and playing guitar. To schedule a commitment-free consultation please call 469-744-3610 or fill out this form to get started.