Real estate investment is an opportunity to generate regular income and achieve capital appreciation in a stable asset held over a 5–15 year period. Real estate investors typically compare investment opportunities start by using one key metrics: Capitalization Rate, aka Cap rate.
In this article, we highlight how you should understand how to compute the cap rate and how to use cap rate when comparing different real estate crowdfunding investment opportunities.
This is part 1 of 4 articles covering the real estate cap rate:
- What is the real estate cap rate?
- What you need to understand about the real estate cap rate?
- How does the real estate cap rate form part of your investment analysis?
- How leverage helps you achieve your investment goal in real estate.
Part 1: What is the real estate cap rate?
Cap rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. It is calculated by dividing the property’s net operating income (“NOI”) by the current market value or acquisition price of a property.
Capitalization rate = Net Operating Income / Current Market Value (Source: Investopedia)
Once an investor knows a property’s cap rate in a specific market, the cap rate can be used to compare with other types of real estate cap rates located in different markets around the world to understand which is more suitable to their investment preference. We have made a quick guide for you below:
Let’s use an example: an investor (Bill) wants to achieve a 12% annual return over 5 years by investing in real estate.
Bill decides to purchase an office building for $600,000 that generates $60,000 of net operating income (NOI), which represents a 10% cap rate. This means the property value would need to increase by at least 2% per year to meet Bill’s goal of 12% annual return.
Bill decides to achieve his investment goal by being more dependent on the cash flow (net operating income) generated as rent by the office building’s tenants, rather than a strong capital appreciation.
In this example, Bill is characterised as a defensive, income-based real estate investor seeking real estate investments that require minimal out of pocket expenses (e.g. refurbishments). In case you are wondering: yes, we will cover different investing style and types of investment play in future blog posts.
In Bill’s case, the cap rate is a key metric to begin his initial screen to compare real estate investment opportunities. For example, a shopping mall being sold at an 8% cap rate means that Bill would rely on (i) strong capital appreciation and/or (ii) leverage in order to achieve Bill’s goal of 12% annual return.
Cap rates are an important way to screen investments and narrow down a list of investment opportunities which suit your individual preference. Once you’ve decided on which investment opportunity to pursue, you will need to gain a better understanding of the real estate’s location and market conditions to form your investment analysis.
An important aspect here is timing — something which Denzity wants to clarify with ‘cap rate compression’, explained below.
What will we cover in Part 2?
We have just scratched the surface when it comes to cap rates! There are more metrics you should take into account when making an investment decision.
In our next article, we will discuss how you should understand and compare the cap rates of different types of real estate located in different places around the world to decide on which best suits your investment preference.
We at Denzity are here to help you understand the key metrics and provide insights. We hope these articles provide you with insight into the real estate investment process and journey!