Cap rate or capitalization rate or just cap is the ratio of yearly rental earnings of the asset over the buy price. This estimate is often shown on industrial asset listings. So you must know this jargon if you want to spend in industrial real estate. It's ordinarily a estimate between 3% to 10%.
For those who spend in the stock market, cap rate is the equivalence of the inverse of P/E ratio. So a cap of 5% is equivalent to P/E ratio of 20. The main contrast is in real estate the earning is real while it's accounting earning in the stock shop where earning can be reinstated years down the road!
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The higher the cap the higher rental earnings the asset produces and thus the less money you need for down payment. Experienced investors often look at the cap to screen out properties with low rental income. Some investors prefer properties with the cap that is higher than the interest rate they pay for the loan. That way they know they secure more from the tenants than they pay the bank.
When the asset has high vacancy rate, listing brokers often show proforma (or potential) cap instead to catch investors' attention. Let's use the following example to illustrate the point. A asset is listed for M and is 90% leased. It has gross leases with an actual gross earnings of K/year and K of yearly expense. Assuming the proforma earnings is 0K/year when it's 100% leased at higher shop rent. So 3 distinct listing brokers could display 3 distinct cap rates for the same property:
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o The first broker may use Noi (Net Operating Income) of K/year (K of gross earnings less K of expenses) and thus the net Cap rate is 6%. This broker calculates the cap the way it should be.
o The second broker may use the gross earnings of K and so the gross Cap rate is 9%.
o The third broker may want to use the proforma earnings of 0K to get investors' attentiveness and thus the proforma Cap rate is 11%!
So as an investor, you need to know what cap, e.g. Net, gross or proforma the broker uses. Otherwise you may offer too much for the property. At the same time, when you tell your broker to look for properties with a unavoidable cap rate, make sure the broker knows what cap rate you have in mind.
The returns of a industrial asset venture come from 4 sources: appreciation, cash flow, i.e. Cap rate, depreciation (tax writeoffs), and necessary discount from your mortgage payments. If you spend in the "right" property, the biggest chunk of your venture return should come from appreciation. There is often a disagreement between cap rate and possible for strong appreciation. Properties that offer possible for strong appreciation, e.g. Newer properties or ones in good location tend to have lower cap rate. On the other hand, properties that are in poor condition, or have ground lease are much harder to sell. As a result, seeder will try to attract the buyers with a higher cap rate. If you see a asset with unusually high cap rate in California, e.g. More than 7%, you should ask yourself "what's wrong with this property?" Chances are you will find a compelling theorize why it is so high.
Is the asset with highest cap the "best" property? The short respond is no. If venture was that simple, you would not need an venture advisor. Cap rate should be one of the assorted other factors you think whether you should spend in a property. It should not be the only factor. Besides, you can enhance the cap by
o Increase the occupancy rate.
o Raise the rent when the current leases expire.
o Negotiate for leases with yearly rent increase.
o Improve the asset to attract more upscale tenants.
o Reduce the expenses not reimbursed by the tenants.
By doing so, you can growth the cap rate and consequently the value of your investment.
What market Real Estate Investors Should Know About Cap Rate
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