How to interpret cap rates?

As an investor, it is important to be well-versed in the fundamentals of the real estate market. One key metric investors need to know is the capitalization rate, more frequently referred to as the cap rate. 

Cap rates are one of the central metrics investors look at when determining potential for a good investment. In this blog post, we will demystify cap rates and explain why they matter in the property acquisition process and how we use them in our acquisition process here at Landa.

What is a cap rate?

A cap rate is defined as the ratio between a property's net operating income and its purchasing price. Net operating income (NOI) is calculated by subtracting all expenses from net revenue. These expenses can include components like property taxes, insurance, utilities, and, repair and maintenance fees. 

In other words, the cap rate calculates the expected return on an investment vis-a-vis expected income. 

The cap rate equation looks like this: 

For example, let’s say an investment property has a NOI of $100,000 and is currently valued at $1 million. 

 => $100,000/$1,000,000=0.10 or 10%

This would give the property a cap rate of 10%. 

*Note: while cap rates can help analyze an investment property they are merely a snapshot in time. They are calculated using current property value and do not take into account future property appreciation (or depreciation). 

All else equal, buyers generally seek higher cap rates on purchases, and sellers seek lower cap rates on sales.

Why do cap rates matter?

Now that we've defined what cap rates are, let's dive into what they mean in terms of opportunities and risks. 

Even though the rule of thumb is “the higher the cap rate, the higher the potential return on investment,” there’s more to it than that. Cap rates are impacted by external factors like property location, market fluctuations, and interest rates.

Location

Location can mean many things beyond urban vs. suburban, or coastal vs. inland. Housing demand, employment rates, school zones, median household income, and even proximity to the nearest train station are all location-based metrics. Ultimately, all these factors together play an important role in generating the market value of houses in an area, which, you guessed it, affects the cap rate.

Interest Rates

Changes in federal monetary policy tools like interest rates can also impact cap rates, especially since debt is part of the net operating income (NOI) calculation. 

How does this occur? 

Higher interest rates increase the cost of financing properties, driving down property values and ultimately lowering cap rates. Furthermore, when interest rates are low, it is generally easier for investors to borrow money to purchase an investment property. This can lead to an increase in demand for investment properties, potentially driving up property values, and effectively increasing cap rates.

The power of purchasing price

Typically an investor wants to buy properties with high cap rates and sell at low cap rates to get the most return on their investment (ROI). 

However, cap rates are imperfect indicators for gauging ROI. Purchasing price, for example, demonstrates how cap rates are a flawed metric for determining the value and return of an investment.

Purchasing price plays a significant role in calculating the cap rate as the fixed denominator of the equation. The higher the purchase price of the property, the lower the cap rate will be, all else being equal. But a more expensive property is not necessarily an inferior investment, nor is a “cheap” property a great investment. All components of the cap rate must be analyzed together. 

When do cap rates matter? 

Cap rates play an important role in the selling and buying processes. 

When selling a property, the seller will often use the current cap rate to price the property. They will compare their property's cap rate to similar properties on the market and adjust their asking price accordingly.    

Buyers also use cap rates to assess whether or not a particular property is worth purchasing. Buyers will look at both the current cap rate and projected future cap rates when making their decision. If they believe that the current cap rate is below market value or has high potential future value, they may elect to purchase the property to collect future appreciation. 

Cap rates may also indicate the number of years it will take for the investor to recover their initial investment. For example, if an investor paid a million dollars for a property with a net operating income of $100,000 and a capitalization rate of 10%, they can project that their profit generation timeline may take 10 years if all factors remain stable. 

While cap rates provide an excellent starting point for investors, they do not take into account the level of risk associated with an investment which is why many investors turn to risk-adjusted returns for a more comprehensive measure of expected return. 

Beyond cap rates

Landa’s acquisition strategy typically targets a cap rate range between 4-10%. All else being equal, a 4% cap rate is generally less risky than a 10% cap rate. However, our acquisition process layers in risk-adjusted returns which account for the level of risk associated with an investment. Risk-adjusted returns provide investors with the ability to compare properties with different risk levels. By adjusting for risk, risk-adjusted returns ultimately provide a clearer indication of the expected return on an investment relative to its level of risk.

Risk factors to consider during the property acquisition process include location, tenancy, cash flow volatility, and asset quality. This is why understanding the market, researching macroeconomic conditions, and conducting property inspections to assess the quality and longevity of a property - are areas into which Landa expends significant resources and energy.