Are you scared to have your money in the stock market (like I am) but also tired of almost no return on investment with your money at the bank? Do you really like the idea of being invested in income producing real estate with results you can actually see? If so, you will need to learn the terms of real estate, and one of the most important terms you need to understand is CAP rate, which stands for Capitalization Rate. It’s how investment properties are measured.
As a real estate investor that many people look to for advice, the number one question I get asked is, “What CAP rate do you buy?” but this is the wrong question. One piece of data doesn’t substantiate a deal. CAP rate is important but don’t get locked into focusing just on one term. All the pieces of data matter.
With that caveat, to understand a CAP rate you simply take the building’s annual net operating income divided by purchase price. For example, if an investment property costs $1 million dollars and it generates $75,000 of NOI (net operating income) a year, then it’s a 7.5 percent CAP rate.
Usually different CAP rates represent different levels of risk. Low CAP rates imply lower risk, higher CAP rates imply higher risk. The question is, what is the right CAP given the riskiness of the deal?
When looking at CAP rates and what the right CAP rate should be for a property, you need to look at several things:
To say that location is everything might be an overstatement — but I don’t believe it is. Location matters because a location is what drives demand.
Is the property in Manhattan or rural West Virginia? A larger, wealthier,and better-educated population will drive a local economy more, this is why CAP rates are lower in a place like LA than in Memphis. This is why even within large metropolitan areas CAP rates can be significantly different from each other, with properties near downtown usually having lower CAP rates (and risk) than properties in the suburbs. But again, there are no strict rules to follow, every location has its perceived risk.
If the Fed adjusts rates, that can fluctuate CAP rates up to 1 percent, even with no changes to the property itself. If you are a real estate investor, rising interest rates will mean a fall in property values. When interest rates rise the cost of debt rises and that decreases your net cash flow. This is why even though you don’t have much direct control over interest rates, you need to be aware of what they are and what direction they might be headed.
You can buy many different types of property: office, industrial, retail, hotel…but I only do one type of asset –multifamily. This has the lowest perceived risk, so it usually has the lowest CAP rates. People will always need a place to live, no matter the economy. The boutique hipster café will come and go, but that 64 units next door will be there even when the economy tanks.
Remember — the lower the CAP rate, the higher I can sell it. What’s a good CAP rate? It depends. I would have made a fortune in San Diego 20 years ago buying extremely low CAP rate properties. Think about the whole deal, like how you will exit, not just the current CAP rate.
There is one number more important than the CAP rate: 1.25
That’s the Debt Coverage Ratio you want. Look at this before you look at the CAP rate. You want the NOI bigger than the debt—a minimum 25% more income than debt. I prefer 1.50 for properties I take on.