|
As a real estate investor, you
hear mention of cap rates all the time.
Cap rates have historically been used by real estate investors to decide
when and what to buy and when to sell.
Generally, the lower the cap rate, the better for the seller and, the
higher the cap rate, the better for the buyer.
Cap rate generally relates to the return on investment the buyer expects
to receive and determines a purchase price.
Cap rate is stated in percentage terms and is calculated by dividing the
net operating income (NOI) of the property by the cap rate desired. In other words, assuming NOI of $100,000, a
cap rate of 5% will produce a purchase price of $2,000,000 and a cap rate of 8%
will produce a purchase price of $1,250,000.
10%
cap rate these days would be attractive for a buyer, but would be hard to find. Cap rates for most 1031 Exchange replacement
properties are coming down especially since there is so much competition to buy
real estate after the stock market plunge a few years ago. It is a matter of supply and demand (and low
interest rates). As a seller, you may be
happy with the low cap rate generated by the purchase price buyers may be
willing to pay, but when you put your buyer’s hat on, the same low cap rate may
apply to your purchase—we are in a seller’s market which is no fun when you are
a buyer. You may be able to sell in a
region where prices are high and buy in a region where prices are low, but it
is very difficult to achieve both if you are not willing to travel far and not
able to analyze and compare properties in far flung locations.
Cash
flow generally is the amount of NOI left after debt service (mortgage
payments). The higher the mortgage
payment, the higher buyers want the cap rate to be when they buy so that, after
mortgage payments, they end up with more money in their pockets in relation to
their investment. A low cap rate and
high mortgage interest puts the squeeze on cash flow investors receive. Theoretically at least, cap rates should rise
as mortgage interest rates rise.
However, as mentioned above, the current market is generally not
reflecting that because there is a lag between rising interest rates and
sellers lowering their sale price expectations and, with the intense
competition to buy real estate, the seller’s market continues and many buyers
are simply willing to accept lower cap rates (which is good when you are
selling your relinquished property).
Return
on investment (sometimes referred to as internal rate of return or IRR) is the total
return on a property which an investor receives between purchase and sale
(taking into consideration cash flow along the way and ultimate profit, and
maybe factoring in tax savings), and may be stated in an annual percentage rate
per year looking back over the holding period.
Sometimes people talk about “average rate of return”, but it is not
usually the same as IRR, and often is larger and therefore somewhat misleading
to an investor. |
