Considering Cap Rates In Today’s Market
If an investor is considering what to look for in a real estate investment, a cap rate is one of the first factors they review. They want to know their return before debt service. You can find the cap rate by taking the net operating income of a property and dividing it by the purchase price.
When looking at cap rates, keep in mind that these figures are sensitive to changes in the market. It can be helpful to consider other trends that could impact the cap rates in your area. In the following sections, we’ll look at several points to keep in mind when you research properties and think about their potential return.
Cap Rates and Interest Rates
If you look at cap rates for different properties, keep in mind that these figures are very sensitive to interest rates. As mortgage rates have rates have gone up during the last years, so have cap rates. Investors today are typically looking for neural or positive leverage. That means that the rate they are borrowing at is at the same level as the cap rate, if not above.
I remember early in the 2000s, some investors would actually accept a lower return than what they were borrowing for. They did this because they hoped they could make up ground by increasing the net operating income. In other words, they felt that the upside would offset and warrant this. Unfortunately, that didn’t’ play out in some cases, as property values didn’t increase and investors had to pay high rates on their debts. In some cases, they were unable to exit out of the property. Today, investors seem to have learned from these past instances and tend to look for neutral or positive leverage.
Establishing Your Returns
If you take your net operating income and subtract your debt service, that will establish your cash flow. If you divide your cash flow by the amount of equity you have in the deal, that will be your cash-on-cash return. If your debt service is less than the cap rate that you are buying at, you will see that your cash-on-cash return will be higher than the cap rate.
That’s a very important function or benefit of real estate investing. If you can get higher returns than what you’re borrowing at, you’ll essential generate an income off that spread. In this way, you can build up a portfolio and gain long-term returns on a property.
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Other Valuation Metrics
While it can be helpful to look at cap rates, bear in mind that they are not the metric every investor uses. Many are focused on long-term value and might be interested in the price per square foot of a place. These are often easier to establish, as they are public information. Cap rates, on the other hand, are not readily available. You can use privately held data sources such as Costar to get this information. You can also work with an investment sales broker who will have this data.
Once you know the cap rate of a place, along with how it is determined and the trends in the market, you’ll be able to get a better sense of the return you can expect. You’ll want to pay attention to your tolerance for risk, too, and take steps to make sure you’re not overleveraged. Overall, working with a knowledgeable team can help you gain the information you need to make an informed decision on an investment property.