How do you analyze rental properties? In other articles, I showed how to run the numbers with back-of-the-envelope analysis, including the super-simple one percent rule. But the most important rental analysis tool I use is something called a cap rate.
What Is a Cap Rate?
A cap rate is simply a formula. It’s the ratio of a rental property’s net operating income to its purchase price (including any upfront repairs):
|Cap Rate =Net Operating Income (NOI) ÷ Purchase Price|
The formula can be used on the level of an individual property by looking at its net operating income compared to its value. But it can also be used on the level of an entire market by taking average cap rates for a large group of properties.
Importantly, the cap rate formula does NOT include any mortgage expenses. As you can see in the formula for net operating income below, the expenses do not include a mortgage or interest payment.
Excluding debt is part of why a cap rate is so useful. The formula is focused on the property alone and not the financing used to buy the property.
Every investor uses a different combination of down payment and financing. So, a cap rate assumes a property is bought for cash without leverage.
This assumption lets you focus on the merits of the property’s financials instead of being distracted by debt. It also lets you compare the risk of one property or market to another.
How to Measure Risk
Beyond a simple math formula, a cap rate is best understood as a measure of risk. So in theory, a higher cap rate means an investment is more risky. A lower cap rate means an investment is less risky.
It’s the same principle that gives you a lower return for low-risk assets like Treasury bonds (3.03% for 30-year bonds as of 7/20/2018) than for more risky assets like stocks (average annual historical returns close to 10%).
What does it mean to be more risky?
Risk is what Warren Buffett talks about in his #1 rule of investing – “don’t lose money.” As an investor, you can’t just pay attention to returns or profit. You also have to estimate and protect yourself against the possibility of losing money.
So, to better judge risk for your real estate investment purchases, you can start with three major factors that affect cap rates.
3 Major Factors That Affect Cap Rates
Like taking the temperature of the air, a cap rate is just a way of measuring actual investment activity in the real world. And just like geography and weather patterns affect temperature, there are three major factors that affect cap rates:
- Macro-level economics and demographics
- Micro-level market influences
- The type of property
These three factors combine to give each individual property or local market its unique cap rate. Let’s take a look at each one so that you can understand them better.
How Macro-Level Economics and Demographics Affect Cap Rate
Let’s say you buy a property in a major metropolitan area like San Francisco. It’s a big city with a strong, diverse economy. It also has high demand from a constant influx of real estate renters and buyers .
At the same time, San Francisco has a lack of new construction supply because of land shortage and regulatory restrictions.
So as I explained in How to Pick the Ideal Location For Investment Properties, these macro-level economic and demographic factors positively affect real estate values. And that generally makes the real estate in a place like San Francisco less risky for investors to invest their money.
In terms of cap rates, this means San Francisco has low cap rates (i.e. high prices). And practically, this means investors and property owners there are willing to accept lower-income returns because of the lower perceived risk.
On the other hand, the economic and demographic fundamentals of a rural or small town market are different. These locations are economically not as strong as a growing, big city that has a diversified economy. So, investors here demand higher cap rates to compensate for this risk.
Using data from real estate firm CBRE’s North American Cap Rate Report for the 2nd half of 2017, this chart shows the difference in cap rates between markets. The cap rates are for stabilized, infill (i.e. urban), class A apartment buildings in each location.
|Cap Rates For Stabilized, Class A Multifamily Apartments By City – 2017 (2nd Half)|
But cap rates don’t just help you compare different markets. They also help you compare different locations and properties within a market (i.e. micro-level).
How Micro-Level (i.e. Local) Markets Affect Cap Rate
Some micro-level locations within the same market are better than others. To reflect this, commercial real estate buildings are organized into four classes (A, B, C, and D) based on their location and building condition. My article, Where to Buy an Investment Property – the A-B-C-D Rating System, explains how this informal rating system works.
For now, just keep in mind that Class A means the newest, best located, and more in-demand buildings. And B, C, D get progressively older and less desirable. And investors in each class of property demand different cap rates.
Using the same cap rate data from CBRE’s 2017 report, here are average cap rates for class A, B, and C properties within the cities I showed in the previous chart.
|Cap Rates For Stabilized Multifamily Apartments By Property Type A, B, C – 2017 (2nd Half)|
|City||A Class||B Class||C Class|
As you can see, the cap rates increase as you move to lower property classes. This doesn’t mean you shouldn’t invest in Class C or even Class D (I certainly have). It just means you need to understand the risks and figure out how to address them (which I’ll talk about in a later section).
But for now, there is one more factor that affects cap rates. It’s the type of property. I’ll explain with another example.
How Property Type Affects Cap Rate
Let’s say you buy a small residential apartment building in suburban Atlanta, Georgia. The market cap rate for your apartment building will typically be less than the cap rate for a small retail (i.e. store) shopping center in the exact same location.
Why the difference between residential and retail? Again, it’s risk.
During a recession, people will still need to live somewhere. So, an apartment building will likely stay full, even if rent rates are a little lower.
But a flower shop renting the retail location might go out of business during a recession. And that means the owner of the building could face long vacancies and much lower rents.
You can again see this difference in cap rates between property types using the CBRE North American Cap Rate Report for the 2nd half of 2017. Here are the average cap rates by property type nationally:
|North American Average Cap Rates by Asset Class – 2017 (2nd Half)|
Currently single family houses aren’t included in commercial real estate reports like these. But my experience is that they are even lower risk (i.e. lower cap rates) than multifamily.
So, all three of these factors – macro, micro, and property type affect the cap rate of any particular building. Now let’s look at how you can use cap rates as a tool to analyze and buy better real estate deals.
How to Use Cap Rates as a Rental Property Investor
So far the idea of a cap rate may seem academic. It’s just a number in a report that measures an abstract concept like risk.
But in reality, a cap rate is a very practical tool. As a rental property investor, you can use it to:
- Pick a market, submarket, or property type to invest in
- Set goals and perform analysis for property acquisitions
- Decide to sell an existing property
In other words, a cap rate helps you make good decisions. And good decisions lead to you accomplishing your overall real estate and financial goals.
I’ll share an example in order to explain how you can use cap rates with your investment decisions.
Example of Analyzing Two Different Properties With Cap Rates
Let’s say you decide to buy a small apartment building. You and a business partner have saved a chunk of cash, and you plan to use that as a down payment. You’ll finance the balance of your purchase price with a mortgage loan.
Your local real estate agent uses the normal sources to look for properties, including the MLS (multiple listing service), Loopnet.com, and networking.
After a couple of weeks of searching, she presents you with two different acquisition opportunities.
Property #1 – Stable Income Producer at 6.48% Cap Rate
Property #1 is a 10-unit building available for a price of $1,000,000. Your agent considers it a class B property. It’s fully rented, needs no major repairs, and has a good management company in place. The location also has good long-term prospects for population and economic growth.
Here are the numbers:
- $9,000 = total monthly rent ($900/unit)
- -$3,600 = monthly operating expenses
- $5,400 = net operating income per month
- $64,800 = net operating income per year (5,400 x 12 months)
- 6.48% cap rate ($64,800 ÷ $1,000,000)
You like this deal because it produces stable income and has good long-term prospects. It also doesn’t have any major “gotchas” or moving parts. You can just buy it and immediately start collecting income using a 3rd party manager.
Now your agent presents you with Property #2.
Property #2 – 6.35% Cap Rate But an Opportunity to Add Value
Property #2 is a 15-unit building available for a price of $850,000. Your agent considers it a C class property, but the location is up-and-coming. Other investors are remodeling properties and raising rents. So, there is an opportunity to add value and potentially make a better return.
Here are the purchase numbers:
- $7,500 = total monthly rent ($500/unit)
- -$3,000 = monthly operating expenses
- $4,500 = net operating income per month
- $54,000 = net operating income per year ($4,500 x 12 months)
- 6.35% cap rate ($54,000 ÷ $850,000)
But remember there is an opportunity to add value and improve the financial picture. Your agent and your property manager are very confident that you can spend $150,000 ($10,000/unit) and increase the rent from $500 to $700/month for each unit.
Here are the new numbers after this improvement:
- $10,500 = total monthly rent ($700/unit)
- -$3,500 = monthly operating expenses
- $7,000 = net operating income per month
- $84,000 = net operating income per year ($7,000 x 12 months)
- 8.40% cap rate ($84,000 ÷ $1,000,000)
This scenario will take more coordination. There is also risk that the plan won’t work. The local or national economy could have problems before you finish. Or you might not execute the repairs or rent raises well enough.
But if you can address those risks and make the effort, the reward on the back-end is a much higher cap rate (i.e. income) for the same total purchase cost of $1 million.
What’s a Good Cap Rate For Rental Properties?
Which property would you buy? Property #1 with the stable 6.35% cap rate? Or Property #2 with the more risky but more profitable potential 8.40% cap rate?
With investment decisions, there are no clear-cut answers.
A “good” cap rate will depend on your personal investment criteria and preferences.
Property #1 in the prior example could be a good fit for investors looking for a more stable, passive experience. And because of its solid location and positive future outlook, the numbers could get even better with time.
Property #2 could be a good fit for the more entrepreneurial investors. The potential returns are bigger if everything goes well. But there is also potential for lower returns or even losses.
I certainly fall into the entrepreneurial investor camp. In fact, I bought a very similar deal to Property #2 just a couple of years ago. It turned out very well.
But I can also imagine scenarios as I have more capital where investing in Property #1 could make sense.
What’s Your Outlook For the Future?
A “good” cap rate also depend on your outlook for the future of a property and location.
For example, let’s say you feel confident that the prices and rent for a property in nice location in San Diego, California will continue to grow for years to come. As a result, you may choose to accept a cap rate of 4% to 5% today even though the interest rate on your mortgage costs about the same amount!
You can probably guess my opinion about this strategy. I don’t like placing bets on an investment strategy that depends on speculation to succeed. It may be smart speculation. But the amount and timing of growth are still just educated guesses.
Instead, I like to choose markets and properties with reasonable current cap rates AND good long-term prospects. I’ve been fortunate to have this type of market where I live in the upstate of South Carolina. But if I didn’t, I would invest at a distance somewhere else.
After all, the income from these properties is what we aspiring early retirees use to build wealth and reach financial independence. By accepting cap rates so low that you produce no income today, your growth (and your path to financial independence) depends 100% on outside forces. That doesn’t leave me feeling warm and fuzzy inside.
Before we finish the topic of cap rates, there is one more factor to consider – interest rates. It’s something you have little control over, but it can affect both cap rates and your overall investing strategy.
How Interest Rates Affect Cap Rates
I’m sure you’ve noticed news about interest rate changes from the Federal Reserve. This rate is technically called the federal funds target rate, and it’s important because it can affect other rates throughout the economy, including cap rates.
Factors like local market economics, demographics, and other micro-level criteria affect cap rates the most. As I’ve explained, they matter because they’re the core fundamentals of real estate.
But because real estate values depend heavily on debt financing and national capital markets, interest rates also play a large role. So, changes in interest rates can increase or decrease cap rates even as a property or market stays the same.
For example, let’s return to Property #1 that was available for a price of $1 million at a 6.48% cap rate. Let’s say changes in overall interest rates in the economy push the market cap rate for this property up to 7.5%.
With the same net operating income, the property would now be worth only $864,000 ($64,800 ÷ 7.5%). That’s a $136,000 or 13,6% decline with no changes in the overall fundamentals of the real estate itself!
Now, will that actually happen? Perhaps. But not necessarily.
The relationship between interest rates and cap rates is complex. A change in interest rate does NOT always mean a change in cap rate.
This report from TIAA (Real Estate: The Impact of Rising Interest Rates) showed that interest rates and cap rates do have some correlation (0.7 is the correlation coefficient for statistics nerds who want to know). But it’s not a perfect 1, which means interest rates and cap rates have also moved in different directions in the past.
But the rough relationship between interest rates and cap rates is a good warning. Make sure your property’s location, income, and debt structure are strong enough to withstand future financial shocks.