Are you scared to have your money in the stock market (like I am) but also tired of almost no return on investment with your money at the bank? Do you really like the idea of being invested in income-producing real estate with results you can actually see? If so, you will need to learn the terms of real estate, and one of the most important terms you need to understand is CAP rate, which stands for Capitalization Rate. It’s how investment properties are measured.
As a real estate investor that many people look to for advice, the number one question I get asked is, “What CAP rate do you buy?” but this is the wrong question. One piece of data doesn’t substantiate a deal. CAP rate is important but don’t get locked into focusing just on one term. All the pieces of data matter.
With that caveat, to understand a CAP rate you simply take the building’s annual net operating income divided by purchase price. For example, if an investment property costs $1 million dollars and it generates $75,000 of NOI (net operating income) a year, then it’s a 7.5 percent CAP rate.
Usually different CAP rates represent different levels of risk. Low CAP rates imply lower risk, higher CAP rates imply higher risk. The question is, what is the right CAP given the riskiness of the deal?
When looking at CAP rates and what the right CAP rate should be for a property, you need to look at several things:
To say that location is everything might be an overstatement -- but I don’t believe it is. Location matters because a location is what drives demand.
Is the property in Manhattan or rural West Virginia? A larger, wealthier,and better-educated population will drive a local economy more, this is why CAP rates are lower in a place like LA than in Memphis. This is why even within large metropolitan areas CAP rates can be significantly different from each other, with properties near downtown usually having lower CAP rates (and risk) than properties in the suburbs. But again, there are no strict rules to follow, every location has its perceived risk.
If the Fed adjusts rates, that can fluctuate CAP rates up to 1 percent, even with no changes to the property itself. If you are a real estate investor, rising interest rates will mean a fall in property values. When interest rates rise the cost of debt rises and that decreases your net cash flow. This is why even though you don’t have much direct control over interest rates, you need to be aware of what they are and what direction they might be headed.
You can buy many different types of property: office, industrial, retail, hotel…but I only do one type of asset --multifamily. This has the lowest perceived risk, so it usually has the lowest CAP rates. People will always need a place to live, no matter the economy. The boutique hipster café will come and go, but that 64 units next door will be there even when the economy tanks.
Remember -- the lower the CAP rate, the higher I can sell it. What’s a good CAP rate? It depends. I would have made a fortune in San Diego 20 years ago buying extremely low CAP rate properties. Think about the whole deal, like how you will exit, not just the current CAP rate.
There is one number more important than the CAP rate: 1.25
That’s the Debt Coverage Ratio you want. Look at this before you look at the CAP rate. You want the NOI bigger than the debt—a minimum 25% more income than debt. I prefer 1.50 for properties I take on.
This Blog courtesy of Will Cook, WILL COOK GROUP| Keller Williams Luxury Homes, Palm Springs, CA | DRE #01879277
Ranked in the top 1% of all agents valley wide and named one of the Palm Springs Life Top Realtors for 2019, 2020, and 2021; Will is an Associate Broker/Team Leader of the WILL COOK GROUP with Keller ....
Should you require assistance in navigating our website or searching for real estate,
please contact our offices at
The information being provided by SoCalMLS, CRISNet Regional MLS, CARETS is for the consumer's personal, non-commercial use and may not be used for any purpose other than to identify prospective properties consumer may be interested in purchasing. Any information relating to real estate for sale referenced on this web site comes from the Internet Data Exchange (IDX) program of the SoCalMLS, CRISNet Regional MLS, CARETS. ZipRealty, Inc. is not a Multiple Listing Service (MLS), nor does it offer MLS
access. This website is a service of ZipRealty, Inc., a broker participant of SoCalMLS, CRISNet Regional MLS, CARETS. This web site may reference real estate listing(s) held by a brokerage firm other than the broker and/or agent who owns this web site.
The accuracy of all information, regardless of source, including but not limited to open house information, square footages and lot sizes, is deemed reliable but not guaranteed and should be personally verified through personal inspection by and/or with the appropriate professionals. The data contained herein is copyrighted by SoCalMLS, CRISNet Regional MLS, CARETS and is protected by all applicable copyright laws. Any unauthorized dissemination of this information is in violation of copyright laws and is strictly prohibited.
Copyright 2022 SoCalMLS, CRISNet Regional MLS, CARETS. All rights reserved. Certain information contained herein is derived from information which is the licensed property of, and copyrighted by, SoCalMLS Inc
Data last updated: January 23, 2022 5:58 AM UTC
If a listing displays "Short Sale/Subject to Lender Approval" then that listing has been identified by the seller and the listing broker as a "Short sale." This means that, at the listed price, the proceeds from the sale may not be adequate to pay all liens and costs of sale. Any offer made that does not fully cover the existing amount(s) owed to the lienholder(s) plus the costs of sale could be subject to lienholder approval, which approval may be exercised at the sole and exclusive discretion of the lienholder(s).