Let’s say you have a deposit in the bank, but you are not satisfied with the interest rates and want to earn more. You must understand: the higher the opportunity to earn, the higher the probability of losing all the money. If you understand the risks and have free funds, it may be worth learning how to invest in securities that are traded on the exchange. Another popular investing direction is real estate.
Each investor should answer the question: what is the main goal of investing? The strategy, the choice of the object, the time for which the finances are invested, as well as the risks, profitability, and payback of the project depend on this. Another factor to take into account is the cap rate.
Capitalization
First, let’s recall what capitalization means. It is a transformation of funds (part of net profit or all profit, dividends, etc.) into additional capital, additional production means, which results in an increase in the size of own funds.
Real estate capitalization, in short, is the value of the real estate, which, under the influence of various factors, can rise or fall. It is significantly influenced by characteristics such as the location of the property, condition, and functional purpose.
Real estate is a product that differs from other investments in its fundamental nature. During its existence, real estate gradually wears out. It is the percentage of depreciation that determines the condition of the property, and therefore directly affects its capitalization.
Capitalization rate
Cap rate is an important term in real estate investing. To put it simply, it is essentially the rate of return that the market (i.e. investors) are willing to pay for a particular type of asset in a particular area. You should know that it has nothing to do with financing. Net operating income accounts only for expenses related to servicing the property and not the debt service. It does not matter how you were able to acquire it. The capitalization rate assumes you own the building with no debt.
Why should you know this financial indicator? A capitalization rate can have a big impact on the projection that you are putting together for a particular investment. It also allows evaluating possible deals to buy against each other. They are a true reflection of value because vacancy and expenses are taken into consideration. The vacancy factor is taken into account when calculating the NOI.
It might sound a little counterintuitive, but a higher rate also translates into increased risk. Let’s use a couple of examples to demonstrate this. An investor is looking at a property that costs $1 million and has an NOI of $75K. If we use the formula above, the cap rate turns out to be 7.5%. Another property costs $500K and gives an NOI of $50K (10% cap rate). Finally, there is an option that costs $5 million with an income of $250K (5% cap rate).
It might seem that a higher cap rate here will be the best choice. However, investors are willing to pay a premium for a lower income that is not going to fluctuate very much. So conversely, the opposite is true. If you have a 10% cap rate and this is in a place where people are moving out due to unemployment or other reasons. Then, you will have a 50% vacancy and the 10% capitalization rate will no longer sound so good. Thus, know that there many other things that you will evaluate in the process.
If you are an investor and looking for a long-term hold, a relatively high capitalization rate is very important because the income you are going to receive should be as stable as possible. There are downsides, including not being able to raise the value/price that much. This financial measure is not as important if you are a value-add investor. If you are looking for something to turn around, in that case, the cap rate really does not matter.
Example
If you take a net operating income of $125,125 and divide it by the amount offered for the building or its price, let’s say $1,525,000, you will arrive at an 8.2% cap rate.
Now, consider this situation. Your rental apartments have a gross income of $280K a year. Your operating expenses are $150K, so your net operating income is $280K – $150K or $130K. Now, let’s look at how the value of your property would change depending on the value of the cap rate.
If we input our NOI value and cap rate into the formula, we can compute the third component or how much the market is willing to pay. Below are capitalization rates and associated object values.
- 7% – $1,857,143
- 8% – $1,625,000
- 9% – $1,444,444
It might seem a little bit counterintuitive, but if the capitalization rate in your area rises, it means that the investors are demanding a greater rate of return. Thus, they will pay less for the same NOI because they need a greater return.
As you can see, only 1% gives us drastically different property values. If the investors were willing to pay close to $2 million when the rate was 7%, once it rises to 9%, you will get about $400,000 less for your asset given that its NOI stays the same.