One of the most important metrics to take into consideration for single family home real estate is cap rate. If you want to be successful in this business, you need to be able to analyze assets and figure out which investment properties are worth pursuing.
Make sure to check out our article on the overall strategy for single-family home real estate investing for a broader overview of the topic.
Key Takeaways:
- Cap rate is a crucial metric in single family home real estate investment. It’s the ratio of the net operating income (NOI) of the property to the purchase price.
- The cap rate can compare different types of real estate investments and assist in making investment decisions.
- The cap rate for a single-family rental property should be at least 8%, with a target of 10%.
- Factors such as the property’s location, condition of surrounding buildings, and market dynamics can significantly influence the cap rate.
- Although cap rate is a critical metric, other factors such as cash flow, cash-on-cash return, and internal rate of return (IRR) should also be considered when evaluating investments.
What is a Cap Rate?
In this case, the bank is offering you 1% interest on your $100. They’re giving you $1 for $100 deposited. The cap rate is the rate of return you can expect on your investment. It is analogous to the interest rate on a bond. This is different from the return you are getting on your investment. The term “cap rate” is used to describe the rate of return on a real estate investment property. The cap rate is the ratio of the net operating income (NOI) of the property to the purchase price of the property.
One of the main reasons to use a cap rate is that it is a tool that can be used to compare different types of real estate investments. You can use it to compare returns offered by different deals, provided it is used consistently. Comparing deals side-by-side will help you make investment decisions.
The way in which different types of development are compared is often based on the level of economic development.
Examples of Cap Rate in Use:
The cap rate equation is defined by three parts:
- NOI
- Purchase Price
- Cap rate
If you know the purchase price ($1MM) and NOI ($40,000), you can easily find the Cap rate:
The capitalization rate is 4% when the net operating income is $40,000 and the purchase price is $1,000,000.
If you know two of the parts of the cap rate equation, you can easily find the third. For Example:
If a building sells for $1 million at a 4 percent cap rate, you then know that the net operating income for the property is $40,000.
This equation is used to calculate the cap rate for a property. The equation takes the NOI for a property and divides it by the purchase price, then multiplies it by 100 to get a percentage.
X = $40,000
The cap rate in a certain market is greatly influenced by the specific location. Essentially, property in the San Francisco Bay Area is more expensive than property in the Midwest. This means that one million dollars can be used to purchase assets that bring in a much different NOI. For example:
A building that costs $1 million and has a 7% capitalization rate has an annual net operating income of $70,000.
The building has a Net Operating Income (NOI) of $40,000.
The return on investment for a purchase made in one location may be different from the return on investment for the same purchase made in another location due to factors such as the local market.
Cap rate is also affected by surrounding buildings. The building that was recently updated may have a 5% percent return on investment, while the one that was not updated may have a 7% percent return on investment.
A good rule of thumb for cap rate for single family rental properties is at least 8%, but a target of 10%.
That’s what we like to target in our turnkey investment properties as part of our financial freedom plan.
This means that a lower percentage of an investor’s purchase price is being paid for the income the property generates in better neighborhoods, and a higher percentage is being paid in worse neighborhoods. An “irresistible” property with a 15% cap rate is generally in a bad neighborhood.
Cap rates that are lower indicate less risk, while higher cap rates represent more risk. It is up to the potential investor to decide what level of risk they are willing to take on.
What’s a Good Cap Rate for Investors?
The quick answer is: it depends.
There is no clear answer, but here are three factors to evaluate when deciding what a “good” cap rate is:
Risk Tolerance
As an example, if we compare a 6% cap rate investment to an 8% cap rate investment, we can see that the 8% investment will require less money down.
If you’re looking for a passive and stable investment, the 6% cap property might be a good option for you. It might be in a better location with a better chance of appreciation.
An investor who is willing to take more of a gamble and risk may find that the 8% cap property is a good fit. Although it is less stable, it might have a better upside.
Control
In order to determine what is considered to be a good cap rate, it is important to understand that cap rates can be changed and that there is some degree of control that can be exercised over them.
Just because you purchase a property with a 6% cap rate doesn’t mean it will maintain that rate throughout the lifetime of your investment. By successfully raising the rents on your investment property, you will be able to increase your Net Operating Income (NOI). This, in turn, will change your cap rate and increase your return on investment (ROI).
The Future
What an investor thinks about the future of a market can help them decide if a cap rate is a good deal or not. If you are confident that a market is improving and that properties are increasing in value, you may be more willing to purchase a property with a low cap rate.
You are essentially betting that the market will rise, and you’re hoping the market turns your “OK” investment into a great one.
Analysis Continued
You must understand how to analyze assets and potential investment properties to grow and succeed in the real estate investing business.
Well, that’s 100% true. In addition to understanding Cap rate, there are a few more key formulas and metrics you should know:
Cash Flow
What remains of your monthly rental income after subtracting operating expenses and repair savings is your cash flow.
Cash flow = gross rental income – expenses
For investors who buy and hold onto their investments, cash flow is the key to increasing their passive income. If your goal is to quit your job and live on the beach, you will need a steady flow of cash.
Cash on Cash Return
The cash-on-cash return is a good way to measure how well an investment property will do. The ratio of annual cash flow to the amount of actual cash you invested upfront expresses how much money you will earn each year relative to how much money you invested.
The cash-on-cash return tells you how much cash you’re making on your investment each year. You can calculate it by taking your annual cash flow and dividing it by your initial cash investment.
I look for properties that will give me at least a 7% return on my investment. This is because, over time, you can expect to make about 7% on your investment by investing in index funds. I want to beat index funds.
IRR
The internal rate of return is the rate at which an investment grows over a specific period of time. It includes cash flow and any profits that come from selling a property. In other words, IRR is a property’s expected rate of return.
Although Internal Rate of Return can give you a good indication of how well your investment will do over time, it’s not the first thing I look at. This is because it depends a lot on predicting future cash flow and the sale price. It’s difficult to forecast years in advance since we don’t have crystal balls.
Ways to Increase the NOI
There are several ways that a sponsor can increase rents, including: -Raising the base rent -Charging for utilities -Increasing the frequency of rent reviews -Imposing a minimum lease term -Requiring a security deposit -Adding a late fee One idea would be to ask nicely. You never know. To improve the units would be a more likely method. Depending on your personal morals and ethics, as well as state and local laws, you may also be able to evict problem tenants. It’s just business in many cases.
Some other options to make the building look more luxurious would be to install recessed lights, put more lighting into a unit, or brighten up the lobby area. Improving the landscaping area would also be a good option. This is the type of deal you will see on many crowdfunding sites.
If the work costs the sponsor $10,000 per unit and there are 100 units in the building, it will cost a total of $100,000. If the building’s value increases by $240,000, the sponsor may decide that it is worth it to increase the rent.
“Build to” Cap Rates
Build-to-cap rates is a concept that is just a bit more advanced. The build to cap rate example is a way to figure out if a potential deal is worth doing or not. A sponsor is interested in purchasing a parcel of land for $3 million to build apartments. It’s going to cost him $17 million. $20 million is the total cost of the project he is contemplating.
In scenario 1, the investor will have a building that is generating an NOI of $1 million. This person’s building would be worth $20 million if the surrounding market had a 5% cap rate and the building had a net operating income of $1 million.
You don’t want to build something and not make any money from it. That would be a bad outcome. The sponsor is building to a 5 percent return on investment. There is no point in building a 5 cap if the market rate for properties in that area is also a 5 cap. If you use a build to cap rate, you will not be able to exceed the set rate. You’re not going to make any money. It’s not worth it.
The sponsor is planning to raise the NOI stabilization to $1.4 million, which would result in a 7 percent cap rate. Are you calculating the cap rate as 1.4 million divided by the cost of construction, which would equal 7%? If the market in this area is willing to pay a 5% return, then the value of the building when he completes it is going to be 1.4 million divided by 0.05 times 100. So 28 million. The market value of his property is 28 million, which is 5 times the market value of the property. So this could be a “go” scenario. This deal appears to be a good deal because the market cap is only 2% less than the build to cap.
What Impacts a Cap Rate?
1. Asset Location
The average rate of return for similar properties in the US has remained steady. This allows for a simple comparison. The cap rate of a building can vary greatly depending on the market it is in, especially if that market is rapidly growing. The difference in interest rates between multi-family and office space is significant.
There may be a large difference in cap rates between these two asset classes in smaller metros like Richmond, VA, or growth markets like Austin, compared to larger metros like New York or Los Angeles. Multi-family dwellings typically have lower capitalization rates than office buildings in growing areas.
2. Capital Liquidity
The source of capital for multi-family properties tends to be lower, which is why they have lower cap rates. There are many types of residential and commercial properties that can get loans from Freddie Mac or Fannie Mae, such as apartment buildings. The government offers these loans because they are low risk. They are easy to sell, so if you need to, you can get your money back quickly.
3. Tenant Access/Market Size
The size of the market is a significant factor in determining what the appropriate maximum rate of return on an investment should be. In markets with a small tenant pool, landlords usually charge a higher rent to make up for the risk of the property being vacant. Since smaller markets can’t handle as much development as larger markets, they shouldn’t try to. The larger metros don’t usually have the problem of higher competition to capture and retain tenants.
The exception to this is multi-family, again. Tenants in multi-family units are not seen as individuals, but rather as a commodity, meaning that cap rates are lower even in smaller markets. Specialized CRE, like office buildings, retail buildings, and medical real estate, usually have higher cap rates in smaller markets.
4. Growth Expectations
Growth markets usually have higher cap rates. One of the main factors impacting cap rates is the cost of capital. This means that if growth is low, investment returns will be lower, while if growth is high, investment returns will be higher. It’s something that happens as part of the natural process of buying and selling property.
5. Asset Stability
It is better to invest in stable assets during a recession as they will be worth more in the long run than unstable assets. Buildings with higher operating costs and lower net operating incomes (NOIs) are more likely to have higher initial cap rates. However, building types that are less stable during economic downturns may see a sharp increase in cap rates during a recession. Other examples include retail real estate and hotels.
Final Thoughts
Cap rate is a key metric for real estate investors to understand and use to gauge investment success. The cap rate can be a very useful tool, not just for its mathematical properties, but also for its practical applications. This concept can be helpful when choosing an investment property, setting expectations, analyzing performance, and deciding when to sell.
Cap rate is not the only metric you should use while analyzing investments. There are other formulas and metrics you should also familiarize yourself with. There are a few other things you need to know about real estate investing, like cash flow, cash-on-cash return, and IRR.
Remember, Cap Rate is only a guide for an investor and one of many metrics that someone should take into consideration prior to purchase of a single family home.
Make sure to check out our other articles in this series, including what a fourplex is to further your financial education.
Frequently Asked Questions:
Q: What does cap rate mean in real estate?
A: Cap rate, or capitalization rate, is a metric used in real estate investment. It’s the ratio of the net operating income (NOI) of a property to its purchase price. It provides a rate of return on the investment, much like an interest rate on a bond.
Q: How is the cap rate for a property calculated? A: The cap rate is calculated by taking the net operating income (NOI) for a property, dividing it by the purchase price, and then multiplying by 100 to get a percentage. For example, if a building sells for $1 million with a NOI of $40,000, the cap rate would be 4%.
Q: What is considered a good cap rate for a single family home?
A: A good cap rate for a single family rental property is at least 8%, with a target of 10%. However, it’s crucial to understand that cap rates can be influenced by many factors, including the property’s location, market dynamics, and the condition of surrounding buildings.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor owning properties in multiple states.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here.
