If you’ve dipped your toes into residential real estate investments, you’re likely familiar with terms like rental income, mortgage interest, and amortization. However, when you venture into the realm of commercial real estate, you’ll encounter new jargon, such as “cap rate,” which might seem perplexing at first.
Fear not if you’re unsure about cap rates and their significance; they can be complex to grasp and challenging to calculate. As a passive investor, you won’t be crunching cap rate numbers, but having a basic understanding can be invaluable. In this article, we’ll unravel the mystery of cap rates and explore what passive investors need to know when engaging in real estate syndications.
Cap Rates Defined
Cap rate is an abbreviation for capitalization rate, a metric used to estimate the expected rate of return for a specific property. Investors employ cap rates to gauge the potential return on their investment for a particular asset. When someone mentions a property has a cap rate of 5%, they are essentially referring to the anticipated return on that property if the property were paid for in cash.
How Are Cap Rates Calculated?
Multiple methods can yield a cap rate, so it’s crucial to inquire about the specific calculation method used. However, most cap rates are computed by dividing the property’s net operating income (NOI) by its market value. Let’s illustrate this with an example for clarity.
Cap Rate Example
Imagine a property valued at $1 million that generated $100,000 in rental income over the past year. After covering $50,000 in expenses, the property’s NOI stands at $50,000. By dividing this NOI by the property’s total value:
$50,000 / $1,000,000 = 5%
This implies that if you were to purchase the property for $1 million today, you could anticipate earning $50,000 in net income over one year. In simple terms, this is your Return on Investment (ROI). Another way to look at it is that it would take 20 years of $50,000 returns to recoup your initial $1 million investment.
If the property generated $150,000 while maintaining $50,000 in expenses, the cap rate would be $100,000 divided by $1 million, resulting in a 10% cap rate. In this case, it would take only 10 years to recoup your initial investment value. Higher cap rates signify a faster return on investment and suggest a potentially better investment choice. However, a higher cap rate also means more work needs to be done to generate the returns, as higher cap rates attribute to properties that are older, need significant renovation or are in less desirable areas. As a passive investor, the key is to get comfortable with the sponsor and their track record especially when you buy investments with higher cap rates.
How Are Cap Rates Used?
While some investors heavily emphasize cap rates and seek investments with cap rates of 6% or higher, it’s essential to recognize that cap rates are just one data point based on a single year’s performance. Cap rates overlook other factors, such as loan terms and the time value of money.
Cap rates prove most useful when comparing various properties in the same market. For instance, if you’re evaluating apartments with a 6% cap rate in comparison to others with cap rates of 5.7%, 6.2%, and 6.5%, your property’s cap rate falls in the middle and is reasonably comparable to the rest. A significant deviation from the local average could be a red flag.
Cap rates can also serve as a general indicator of asset class and associated risk. Higher cap rates typically correspond to properties in developing or depressed areas, while lower cap rates are often found in established, more affluent locales. Again, it’s crucial to remember that higher cap rates come with increased risk.
What Should Passive Investors Know About Cap Rates?
Now that you’ve gained insights into what cap rates are, how they’re calculated, and their applications, let’s explore their relevance to passive investors.
The Bottom Line:
As a passive investor, numerous other data points hold more significance than cap rates. The track record of the sponsor team in a real estate syndication investment should be your primary focus.
1. Is the Cap Rate Comparable?
A reputable sponsor team will have already assessed the property to ensure its cap rate aligns with other properties in the area. Nonetheless, it’s wise to double-check that your property’s cap rate is reasonably in line with local averages. If it’s an outlier, this could warrant further investigation.
2. What’s the Reversion Cap Rate?
Here’s a nuanced aspect: the reversion cap rate. Sometimes referred to as the exit cap rate, it signifies the cap rate at the time of asset sale, as opposed to the cap rate at the initial purchase. Remember this critical piece of information – when evaluating a potential real estate syndication deal, ensure that the reversion cap rate is at least 0.5% HIGHER than the current cap rate. This indicates conservative underwriting, accounting for the possibility of a softer market in the future (remember, the cap rate is the denominator in the property valuation formula above so the higher the cap rate, the lower the calculated property value and the more conservative the projected sales price in the sponsor’s underwriting).
Cap rates, in the grand scheme, are a snapshot of a property’s performance at a specific moment. They don’t forecast an asset’s potential or predict your future cash flow. As a passive investor, it’s essential to comprehend terms like cap rates but remember that they are just one piece of the puzzle.
To sum up, while cap rates provide valuable insights into a property’s current performance, they’re only part of the real estate investment puzzle. To gain a comprehensive understanding of how to navigate the world of real estate syndications and make informed decisions, we invite you to join the GrowAbility Investor Club! Also, take the next step towards accelerating your wealth and legacy building by scheduling a call with us today.
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