09 Dec What Passive Investors Need To Know About Cap Rates
What Passive Investors Should Know About Cap Rates When Investing In Multifamily Syndications
If you have ever purchased a residential investment property before, you understand the basics like rental income, interest payments, and mortgage payments, and you likely have an understanding of how amortization works. When you begin investing in the world of commercial real estate syndications, you will start learning terms like internal rate of return (IRR), net operating income (NOI), equity multiple etc., but one of the terms an investor may see when reviewing a real estate deal is the cap rate of a particular investment.
It’s perfectly fine if you don’t fully grasp how a cap rate is calculated because it can be difficult to understand and hard to calculate, but to a passive investor, it would be helpful to know what it is and how it comes into play when determining the property value of a commercial real estate asset.
What we’ll cover here are some basics about cap rates – what a cap rate is, how it is calculated, and how investors use a real estate cap rate, as well as what you would want to understand when you are a passive investor in commercial investment opportunities.
What Is A Cap Rate?
Cap rate (or capitalization rate) is used to determine the rate of return that is anticipated for a particular investment property. Investors utilize the cap rate to estimate their potential ROI (or return on investment or cash return) for investment properties.
When you see that a property has a 5% cap rate, or that properties in a specific area of a market are trading at or around a “5-cap”, then what they are talking about is the future cash flows (unlevered – without any debt) for that property or the properties in that area.
When reviewing a commercial real estate syndication opportunity, cap rates are utilized to help determine what the value of a property is when used in conjunction with other metrics.
How Do You Calculate Cap Rates?
There are a variety of approaches that real estate investors use to come up with the cap rate, so you will want to ask whoever you may be investing with how they calculated the cap rate on that investment opportunity.
Here is the most commonly used method to calculate the cap rate of a commercial property: You would take the property’s NOI or net operating income and divide it by the value of the property to come up with the cap rate.
Cap Rate Example
The best way to explain this calculation is to give you a simple example. Let’s say a property is valued at $10 million and the net rental income is $1 million.
If we have $500,000 in expenses, we arrive at $500,000 in Net Operating Income (NOI). A yearly NOI is calculated by taking all of the annual income and revenues from all sources that the property produces and subtracting all of the operating expenses.
We then would take the NOI of $500,000 and divide that by the market value.
$500,0000 / $10,000,000 = 5%
So What Does This Mean?
So what this means is that if we purchased the asset for $10 million without any debt then we would expect to earn $500,000 net income over the course of the year. This is what investors also call a return on investment or ROI. So, in this case, it would take 20 years to recoup your investment (again unlevered) of $10 million.
If, on the other hand, the property had a gross income of $1,500,000 with the same $500,000 in expenses, the cap rate would be calculated at $1,000,000 divided by $10 million, which would a higher cap rate of 10%. So, in this scenario, it would only take 10 years to recoup the investment of $10 million.
A high cap rate allows for a faster return on your investment capital. Conversely, a lower cap rate will take longer for you to recoup your investment, but there are different levels of risk with higher cap rates that a real estate investor should be aware of before investing. An understanding of the cap rate can help you with your investment decisions, but as a passive real estate investor, you don’t need to know how to calculate the cap rate to be among other successful real estate investors.
How Are Cap Rates Used?
There are prospective investors who put a lot of weight on the cap rate and seek investment opportunities with high cap rates, but this is only one metric that an investor may consider because a cap rate on a commercial real estate property can change from year to year. An investor must also consider other factors such as loan types, hold terms, interest rates, projected returns, the time value of money (TVM), and a variety of other metrics.
When considering investment opportunities in a particular area in a real estate market, then cap rates can be very helpful. So what is a good cap rate? Well, that depends.
So, for example, if you’re looking at an apartment building in a specific area that has a cap rate of 6%, and by comparison, there are other similar properties that have different cap rates of say 5.7%, 6.1%, or 6.5%, then your particular property is at a cap rate somewhere in the middle range – at an average cap rate – and is neither too high nor too low comparatively. That’s a quick, simple way to compare different properties and whether you may be paying too much for a property and also whether you are making a good investment at first glance. There are certainly many more metrics to consider.
What Does a Lower Cap Rate Mean?
If you are analyzing properties in particular real estate markets, and you find a property that has a considerably higher or a considerably lower cap rate, then that is a red flag that you would want to be aware of.
Cap rates can be a simple tool to help you understand the risk level of the investment and are often correlated with the asset class. A property with a high cap rate usually indicates that the area may not be as established and is possibly less desirable, and will tend to be a higher risk property. A property with a low cap rate will tend to be in an area in high demand, and will typically have less risk. As with virtually all investments, a lower cap rate can mean lower risk.
What A Passive Income Investor Needs To Know About Cap Rates?
Now that you’re ready to tackle your initial investment, and in the course of doing your due diligence you’ve determined what the cap rate on a prospective real estate investment, the question is do you need to know the cap rate? Not necessarily.
As a passive investor who is exploring various real estate investments, there are many other factors and metrics that are far more important when trying to determine the returns on an investment and whether or not you want to pursue that investment. For example, the track record of the general partnership team and how well they execute their business plan when they acquire assets should be one of the most important factors when considering making an investment into a commercial real estate syndication.
Here are two ways you may consider using cap rates:
#1 – Is the cap rate of this property comparable to other properties in this specific market/area?
An experienced sponsorship team will always have evaluated the real estate asset to make sure that the cap rate is in line with other comparable properties in the area, but you don’t have to take their word for it. You can do your own due diligence to see what cap rates other comparable properties are trading at in that area and confirm that the cap rate is neither too high nor too low.
#2 – What is the reversion cap rate?
Here’s a term new investors may not be familiar with – Reversion Cap Rate.
The term reversion cap rate and exit cap rate can be used interchangeably because the reversion cap rate is used as a measure of determining the cap rate at sale whereas the asset cap rate that we have been discussing is a measure of a property’s cap rate at the time the asset is purchased.
A smart investment strategy that you will want to see in the underwriting of a potential real estate syndication opportunity is that the reversion cap rate is being underwritten to reflect an INCREASE in the cap rate at sale of at least 0.5%.
This will show conservative underwriting. It shows that the deal sponsors are projecting in their underwriting that the market conditions and/or the property’s condition may be WORSE than it is now and that the property may trade at a lower valuation.
So, if the current cap rate on the property is 5%, then the reversion cap rate should be projected to be at least 5.5% This will indicate that the deal sponsors are being realistic and conservative about the possibility of a market correction or economic factors that may reduce the valuation of the property in the future.
To sum up what a cap rate is – it is simply a metric that is used to determine a property’s valuation at a specific point in time based on the performance of a property at that time and the market conditions where the property is located at that time. It should never be used to determine if you should invest in a deal or not. It is important to remember that cap rates won’t measure the asset’s returns or how much money you will receive in distributions.
As a passive real estate investor, you always want to understand the terms in an investment summary that you may be reviewing, but at the end of the day, the cap rate is not something that holds a lot of weight in evaluating whether or not an opportunity will be a good investment.
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