If you are new to real estate, you are probably wondering
about some of the terms you have heard at your real estate
investment group or seen on the Internet. Understanding
these terms is important to successful real estate
investing. One of these terms is "Cap Rate." Cap Rate is
short for Capitalization Rate. Effectively, the Cap Rate
is the rate of return provided, prior to financing, by the
cash flow of an investment property.
The equation to determine the Cap Rate (CR) of a property
looks like this:
NOI/FMV = CR, where NOI is net operating income from the
property and FMV is the fair market value of the property.
Let me give you a simple example.
Suppose you purchase a property for $500,000. And suppose
your net operating income, after operating expenses but
before any interest, principle or depreciation, is $50,000.
Your Cap Rate is 10%, i.e., 50,000/500,000.
Now, this is your Cap Rate because you know what you paid
for the property and you know its cash flow. But, what
about the Market Cap Rate? The Market Cap Rate is the
average Cap Rate that an investor in a specific market
expects for a certain type of property.
You may wonder, "What is the significance of the Market Cap
Rate for my property?" Well, as Market Cap Rates go up,
values go down. Conversely, as market cap rates go down,
values go up. We can see this simply by restating the
formula as follows:
NOI/CR = FMV
Let's take a look at our example when the Market Cap Rate
changes.
Suppose the Market Cap Rate for your property goes from 10%
to 7%. What does that mean for the value of your property?
To find out, simply divide your net operating income (NOI)
by the Cap Rate. So, 50,000/.07 = $714,000. Your
property's value went from $500,000 to over $700,000
through no effort of yours, but simply because the Cap Rate
went down.
Conversely, suppose the Market Cap Rate goes from 10% to
12%. What does that mean for the value of your property on
the open market? Again, simply divide the NOI by the Cap
Rate. So, $50,000/.12 = $417,000 So, the value of your
property has decreased because the Market Cap Rate has
increased.
What causes the Market Cap Rate (MCR) to change? It's
simply a matter of supply and demand. The more demand for
investment property, the lower the MCR. The lower the
demand for investment property, the higher the MCR.
So what should the Cap Rate of a property mean to you?
A Cap Rate should tell you two things. The first is how
leverage will affect your investment. As long as your Cap
Rate is higher than your borrowing cost (interest rate),
then you should borrow as much as possible with respect to
the acquisition and/or holding of that property. However,
if your Cap Rate is less than your borrowing cost, then you
should either pay cash for the property or find a different
property to buy.
You should also monitor your property Cap Rates to help you
determine when you should sell. If the Cap Rate falls
below your borrowing cost, then you probably should sell
the property. Why? Because in opportunity cost, you are
losing money. Here is an example:
Let's say you purchased your property for $500,000 when the
Market Cap Rate was 10%. And let's say your mortgage is at
7%. Now, suppose the MCR goes to 5%. What should you do?
You should probably sell the property.
At this point, the property is worth $1,000,000. Let's say
you want to maximize your Velocity of Money, so you
refinance to a total of $800,000. Your NOI is still
$50,000. But you are paying 7% on your money. So now,
your interest is $56,000 but your income is only $50,000 so
you have negative cash flow of $6,000. With the MCR below
your borrowing cost, borrowing out the equity puts you in a
negative cash flow position. Instead, you should look at
the benefits of selling the property and buying a new
property with a higher Cap Rate.
Of course, there are some things you can do to increase the
value without regard to the Cap Rate. Any time you
increase your NOI, you increase your value. If you can
make changes to your property to increase the rent or to
decrease expenses, you will increase the value of your
property even if your Cap Rate stays the same.
But any time your cap rate gets lower than your borrowing
rate, you should consider selling the property. Many
people in Phoenix and California got caught in this trap in
the mid-2000's. Cap rates were at an all time low; some as
low as 3-4%. These same people lost many of their
properties to foreclosure because they could not make the
negative cash flow payments.
So pay attention to the Cap Rate in your market for your
investments. If Cap Rates are low, it may be time to sell.
If Cap Rates are high, it may be a great time to buy more
property in your market. A good real estate broker can
give you a pretty good idea of the cap rate for your
property.
Warmest Regards,
Tom
----------------------------------------------------
Tom Wheelwright is not only the founder and CEO of
Provision, but he is the creative force behind Provision
Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth,
business, and tax strategies. Along with his frequent
seminars on these strategies, Tom is an adjunct professor
in the Masters of Tax program at Arizona State University.
For more information, visit http://www.provisionwealth.com .
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