If you’ve invested in residential real estate before, you’re familiar with some important terms like rental income, mortgage interest, and amortization. However, when you first cross into the world of commercial real estate, you’ll see different terms thrown around, like cap rate.
It’s okay if you don’t know what a cap rate is or what it means. It can be challenging to understand and hard to calculate. As a passive investor, you won’t have to do the work to calculate cap rates, but it’s helpful to have a basic understanding of what they are.
Keep reading to find out what a cap rate is, how it’s calculated, how it’s used, and what you need to know about them as a passive investor in a real estate syndication.
Related: Exploring Projected Returns in a Real Estate Syndication
What Are Cap Rates?
Cap rate is short for capitalization rate, and is used to indicate the rate of return expected for a particular property. Investors use cap rate to estimate their potential ROI (return on investment) for a particular asset. They also use it to help understand the value of the property.
When someone says a property has a cap rate of 5%, or that assets in a given area are trading around a 5-cap, they are talking about the return on that property.
How Are Cap Rates Calculated?
Cap rates are generally calculated by taking the net operating income (NOI) and dividing it by the market value. Or if you know the area’s average cap rate, you can divide the NOI by it to get the estimated value. Here’s an example for clarity…
Cap Rate Example
Say you have a property valued at $1 million. Over the past year, it’s brought in $100,000 in rental income.
After paying $50,000 in expenses, we’re left with $50,000 in NOI.
We take the $50,000 NOI and divide that by the total value of the property.
$50,0000 / $1,000,000 = 5%
This means if we bought that property with $1 million right now, we could expect to earn $50,000 net income over the course of one year. This, loosely, is your ROI.
Conversely, if you know the income and expenses, and you know properties are commonly trading at a 5% cap, you can calculate the estimated value.
$50,000 NOI / 5% = $1 million
One way to think about this is that it would take 20 years of returns at $50,000 to recoup your $1 million initial investment.
If the property generated $150,000 in income instead, with the same $50,000 in expenses, the cap rate would be $100,000 (the NOI) divided by $1 million…10%. In that case, it would only take 10 years to recoup your initial investment value.
The higher the cap rate, the faster you’d earn back your investment capital. And everything else being equal, a property with a low cap rate is worth more than the same property would with a higher cap rate. But does that mean a property with a higher cap rate is a better investment choice than one with a lower one?
But wait…
Unfortunately, there’s more to it than that. A higher than normal cap rate on a property may be a sign that it has major issues (i.e., it’s “distressed”…whether physically, or economically). Those might mean they’re opportunities, but they also imply risk.
And a property that’s in a great area and is highly sought after may have a lower than normal cap rate, indicating higher value.
Cap Rates Change Over Time
Last, cap rates change over time. When area cap rates go up, that means prices are dropping, possibly as part of an economic recession. When they go up, prices are climbing.
Of course, everyone wants to buy low (at higher cap rates) and sell high (at lower cap rates). That increases the capital gain at the eventual sale.
But since no one has a crystal ball, it’s impossible to know when you buy which direction they’ll actually go. So when you buy, you have to be sure the property can still be profitable if cap rates rise, which we’ll talk about in a minute with “reversion cap rates.”
How are Cap Rates Used?
Some investors rely heavily on cap rates, looking for investments with cap rates of 7% or higher, for example. However, that’s just one data point (from only one particular year) on an asset.
Cap rates don’t take into consideration other factors like loans or the time value of money. And just because you buy at a high cap rate, that doesn’t mean they’ll go down by the time you sell.
When comparing different properties in the same market, cap rates can be very useful.
As an example, if you’re looking at apartments that have a cap rate of 7%, in comparison to other properties that have cap rates of 6.7%, 7.2%, and 7.5%, your property’s cap rate is right in the middle and fairly comparable to the rest.
If the property had multiple points higher or lower than the others in the area, that should be a red flag to understand the reason why.
Cap rates can also be a good general measure of the asset class and corresponding risk in general. Assets with higher cap rates tend to be in developing areas and those with lower rates may be in more established areas.
What Do You Need to Know About Cap Rates as a Passive Investor?
Now that you’ve read through what cap rates are, how they’re calculated, and how they’re used, do you need them?
Not too much, really.
As a passive investor, there are many data points that are far more important. The track record of the sponsor team on a real estate syndication investment should be the top thing you look at.
Otherwise, cap rate might carry weight in these two arenas:
#1 – Is the cap rate comparable to other assets in the area?
A strong sponsor team will have already evaluated the property to ensure the cap rate is comparable to others in the area, but you may want to double-check that your property isn’t being purchased at a 4% cap while others are 7%. (If it is, there may be a good reason…but you’ll want to understand it and be comfortable with the strategy.)
#2 – What’s the reversion cap rate?
The reversion cap rate is also referred to as the exit cap rate, because it’s an estimate of the future cap rate at the sale of the asset, versus the cap rate at the time you purchased it.
Like we said earlier, when we buy a property, we want to be sure it can still be profitable if the market worsens (i.e. cap rates rise). So when analyzing a deal, we always want to make sure the predicted returns are calculated using a reversion cap that’s higher than what it’s being purchased at.
Typically, we want to see a 0.1% to 0.2% increase for every year of the planned holding period. So with a planned 5-year hold, you want to be sure the reversion cap rate is at least 0.5% HIGHER than the current cap rate. (If nothing else, take that with you from this post!)
If the current cap rate is 5%, then the reversion cap rate should be at least 5.5%. That will be a great indicator of conservative underwriting and that projections include the possibility of the market softening in upcoming years.
Cap Rates – Summary
At the end of the day, a cap rate is a single measurement at a single point in time, based on the current performance of a given property. They don’t measure the potential of an asset. They also don’t measure how much you’ll receive in distributions – they don’t affect the distributions at all actually, though they do affect the capital gain when the property sells.
As a passive investor, you definitely want to know what things mean and understand the terminology when choosing an investment. Beyond that, you probably won’t find yourself troubling to much about the cap rates.
Further reading: Cash Flow in a Real Estate Syndication – Where Does it Come From?
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