Today’s investors, armed with a wealth of knowledge at their fingertips, are in a unique position to assess the potential financial gain associated with commercial real estate investment opportunities. Although there is no shortage of data available online, making sense of it all, and accurately assessing risk, requires an understanding of a wide range of financial concepts.
One factor, in particular, the capitalization rate, or cap rate as it is more commonly known, can be a valuable metric for potential investors seeking data on well-priced opportunities in private placement real estate investing. But what is a cap rate and how, precisely, can you use it to your advantage when considering investing hard-earned money into a real estate venture?
Cap Rates Defined
Although cap rates deliver valuable information to help compare and contrast potential investment opportunities, the data they yield can be easily misunderstood or misinterpreted. In essence, a cap rate is a metric used to represent the annual income a property generates, or its net operating income (NOI), divided by the value, or cost, of the property. The NOI defines the actual revenue a property generates after deducting annual operating costs. Therefore,
- Capitalization Rate = Annual Net Operating Income / Property’s Value
For example, assume that a $1 million real estate project generates an annual NOI of $50,000 after deducting all operating costs. To determine the cap rate for this investment, we would simply divide the $50,000 (NOI) by the $1 million notional value of this property to arrive at a 5% cap rate.
How Does a Cap Rate Help Assess an Investment’s Potential?
When comparing several potential investment properties, cap rates are an invaluable tool to determine which may represent the highest earning potential for an investor. Since a cap rate unlocks data about a real estate investment’s rate of return, it can be a fast, and relatively simple, way to measure and assess risk, and help investors determine overall market trends.
Using the example above, the $1 million property we examined generated an NOI of $50,000 a year for a 5% cap rate. What if we compared this to a similarly valued $1 million real estate property bringing in a higher, $80,000 annual NOI for an 8% cap rate? Which is better?
In this particular example, the higher NOI for a similarly priced property generates a higher cap rate, or annual yield. From an investor’s perspective, a higher cap rate can indicate the purchase price of a property is low, and, therefore, could represent a lucrative investment opportunity.
Pitfalls of Relying Solely on Cap Rates
Although cap rates are a great tool to use when comparing several investment properties, they are not ideally suited to assess the earning potential for short-term opportunities or value-add investments with potential opportunity to improve the NOI. This is because a property’s NOI can fluctuate widely from year to year based on a variety of factors. Additionally, cap rates do not take additional vital details about a real estate investment into account such as:
- The age of the property
- Loan amounts
- Critical data about current tenants
- The property’s location and more
As with any investment opportunity, it pays to thoroughly research all factors involved and seek advice from experienced professionals. Would you like to learn more about cap rates or private placement real estate investing? If so, connect with the Realty Capital Partners (RCP) team today. Reach out to RCP by calling (469) 533-4000 or send us your questions, concerns and comments via email at RCP@rcpinvestments.com.