The first thing all of us consider in determining a fair price for something we are buying or selling is to look at the prices of comparable items that have recently sold. If we are looking to buy a home to live in, we will first want to know the prices of similar homes that have recently sold in the area – and then consider other factors such as the property’s amenities, overall suitability for our families, schools, etc.
When considering investments in income properties additional tools are needed to determine fair market value and “Cap Rate” is one of the most popular. Simply put, Cap Pate is the expected annual return on your investment, excluding the mortgage expenses. By eliminating mortgage costs, the Cap Rate provides a better apples-to-apples figure than can be used to compare income properties against each other when you are initially evaluating various property investment options.
A basic Cap Rate calculation is done as follows:
1. Determine expected gross annual income
2. Determine Net Operating Income by subtracting all anticipated property operating expenses e.g., management expenses, maintenance, insurance, real estate taxes, utilities, HOA dues, etc.
3. Divide the NOI by the property value to calculate the cap rate
As an example, let’s assume that you own a rental property that is valued at $500,000 and it generates gross rental income of $3,000 per month or $36,000 per year. Annual operating expenses include:
$3,000 – Management expenses
$6,000 – Real estate taxes
$11,000 – Maintenance and other expenses
Total annual expenses are then equal to $20,000.
Net Operating Income is therefore equal to $36,000 of gross rent less $20,000 of total operating expenses or $16,000.
The Cap Rate for this property is the Net Operating Income of $16,000 divided by the $500,000 value of the property or 3.2%. Among investors, this is often referred to as “a 3.2 Cap property.”
Cap Rates can be used to compare options for investors who are primarily seeking income. Typical Cap Rates range from as low as 3 for an attractive multifamily property in a high growth area to as high as a 10 (or more) for a property in a less desirable area or a property having greater risk of loss of future income. Since Cap Rates do not consider potential appreciation, patient investors who may be seeking higher total returns consisting of both income and appreciation over a longer time horizon e.g., 10 years, may be willing to invest in area with low cap rates and higher appreciation potential e.g., San Francisco Bay, Manhattan, Miami, etc. Many older investors however will tend to seek higher income properties in areas with higher cap rates and lower potential future appreciation – and begin selling highly appreciated properties in low cap rates to reinvest in higher cap rate areas to achieve greater income. Appreciation is nice – but it does not improve one’s lifestyle unless converted to cash.
Investors also use Cap Rate comparisons as a tool for assessing the relative risks among assets in a similar asset class. As an example, when considering two Walgreen’s drug stores in similar areas, it is likely that the Cap Rates will differ – and sometimes by a large amount. If you find one of the stores to be offered at a 4 Cap Rate and another at a 7 Cap Rate, what can you conclude? In general, the higher Cap Rate signals that there is likely more risk associated with property. For single tenant triple net (NNN) investments like a Walgreen’s, the most common risk factor affecting Cap Rates is the remaining term on the lease. The 4 Cap Rate offering may have a full 15 years of term remaining on tis lease whereas the 7 Cap Rate offering may only have 4 years remaining thereby adding greater renewal risk to the investment.
Cap Rates are often confused with another often-used financial metric, Return-on-Investment or ROI. ROI can provide a more accurate measure of actual cash flow since it does factor in any financing costs. If two similar properties have the same Cap Rate, but one is more expensive to finance, the added financing costs will weaken the net income after debt service obligations for that property. Said otherwise, Cap Rate is the percentage an investor would make on their money if they paid cash for the property, and ROI is an investor’s percentage return when financing costs are factored in.
Finally, most of our investors want to know the net cash-flow of potential investments after all expenses and all taxes are paid out (including personal income taxes). We believe that calculating net cash flow is ultimately the best way for income-oriented investors to compare options – however Cap Rates are a good starting point,
Cap Rates should only be used as an initial tool when comparing investments – and it is unwise to solely make investments based on them. Location, property condition, tenant quality, management, taxes, and many other factors should be considered when making income property investments.
Our team at First Guardian Group can help you wade through the various financial metrics and develop investment options that may be most suitable to meet your objectives. Please us at 866 398-1031 or send us an email at info@FirstGuardianGroup.com for more information.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation. Securities offered through registered representatives of LightPath Capital, Inc. Member FINRA / SIPC. FGG1031, First Guardian Group, and LightPath Capital, Inc. are separate entities.
DST 1031 properties are only available to accredited investors (generally described as having a net worth of over one million dollars exclusive of primary residence) and accredited entities only (generally described as an entity owned entirely by accredited individuals and/or an entity with gross assets of greater than five million dollars). If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney prior to considering an investment. You may be required to verify your status as an accredited investor.