Unlocking the Mystery of Cap Rates: A Beginner’s Guide for Passive Real Estate Investors

by | Feb 21, 2023 | Investing Advice

If you have prior experience in investing in residential real estate, you may have encountered basic terminologies such as rental income, mortgage interest, and amortization. However, as you venture into the world of commercial real estate, you will come across more complex terms such as “cap rate” that can seem daunting and challenging to comprehend. This article aims to shed light on the subject by providing an introduction to cap rates, their calculation, and usage. Although passive investors need not engage in the detailed calculation of cap rates, it is imperative to possess a fundamental understanding of the concept. This article is dedicated to enlightening passive investors on what cap rates are, their significance, and what they should know about cap rates in a real estate syndication.

What Are Cap Rates?
Cap rate is short for capitalization rate and is used to indicate the rate of return expected for a particular property. Investors use cap rate to estimate their potential ROI (return on investment) for a particular asset. When someone says a property has a cap rate of 5%, or that assets in a given area are trading around a 5-cap, they are talking about the return on that property.

How Are Cap Rates Calculated?
There are multiple ways to come up with a cap rate, so be sure to always ask how it was calculated. Most cap rates are calculated by taking the net operating income and dividing it by the market value. Cue the example for clarity –

Cap Rate Example
Let’s talk about a property valued at $1 million. Over the past year, it’s brought in $100,000 in rental income. After paying $50,000 in expenses, we wind-up with $50,000 in Net Operating Income (NOI). We take the NOI of $50,000 and divide that by the total value of the property.

$50,0000 / $1,000,000 = 5%
Assuming a purchase of the property for $1 million, the expected net income for a year is $50,000, which is equivalent to the return on investment (ROI). The ROI would require 20 years to recoup the initial investment. However, if the property generates $150,000 with the same expenses, the cap rate would be 10%, and the ROI period would be 10 years. A higher cap rate implies a faster ROI and a better investment choice. Nevertheless, as a passive investor, one need not have all the details to achieve success.

How are Cap Rates Used?
Some investors rely heavily on cap rates and look for investments with cap rates of 8% or higher, for example. However, that’s just one data point (from only 1 particular year) on an asset. Cap rates don’t take into consideration other factors like loans or time value of money. When comparing different properties in the same market, cap rates can be very useful. As an example, if you’re looking at apartments that have a cap rate of 7%, in comparison to other properties that have cap rates of 6.7%, 7.2%, and 7.5%, your property’s cap rate is right in the middle and fairly comparable to the rest. If the property had multiple points higher or lower than the others in the area, that should be a red flag. Cap rates can also be a good general measure of the asset class and corresponding risk in general. Assets with higher cap rates tend to be in developing areas and those with lower rates may be in more established areas. As with most investments, higher rate means higher risk as well.

What You, As A Passive Investor, Need To Know About Cap Rates?
Now that you’ve slogged through what cap rates are, how they’re calculated, and how they’re used, do you need them?
Not really. As a passive investor, there are many data points that are far more important. The track record of the sponsorship team on a real estate syndication investment should be the top thing you look at.

Otherwise, cap rate might carry weight in these two arenas:

#1 – Is the cap rate comparable to other assets in the area?
A strong sponsor team will have already evaluated the property to ensure the cap rate is comparable to others in the area, but you could double-check that your property isn’t’ 4% while others are 7%.

#2 – What’s the reversion cap rate?
Here’s one that might throw you for a loop – Reversion Cap Rate. Sometimes the cap rate is referred to as the exit cap rate because the reversion cap rate is a measure of the cap rate at the sale of the asset, versus the cap rate at the time you purchased the asset. If nothing else, take this knowledge with you- When evaluating a potential real estate syndication deal, be sure the reversion cap rate is at least 0.5% HIGHER than the current cap rate. This means that the sponsors believe the property/ market conditions will be WORSE than it is now. In other words, they assume things will be in worse condition than they are now and that the property will sell for a lower price. If the current cap rate is 5%, then the reversion cap rate should be at least 5.5%. That will be a great indicator of conservative underwriting and that projections include the possibility of the market softening in upcoming years.

Cap Rates – All Said And Done
At the end of the day, cap rate is a single measurement at a single point in time, based on the current performance of a given property. Cap rates don’t measure the potential of an asset or how much you’ll receive in distributions. As a passive investor, you definitely want to know what things mean and be on the look for this terminology while choosing an investment. Beyond that, you will find that cap rates are one of the last things to be concerned about.