Cap Rate and Desired Returns in Real Estate
One of the key measures in a real estate investment is the cap rate or capitalization rate. What exactly is this and what does it mean? And, what does it mean to you?
The cap rate is simply the return being generated by a property based on a 100% equity scenario. For example, if a property is being marketed for $500,000 with a cap rate of 7% based on existing rents and expenses, it will yield $35,000 in profits annually. Cap rate is profits (exclusive of depreciation) / value of the property.
Knowing this number allows you to compare a particular investment with other investment returns from a mutual fund to a dividend yielding investment to other private investments.
But, really, what does it mean?
The cap rate will vary based on the tenant risk of property, location risk, seller’s delusionality and any number of other factors. Generally speaking, the higher the cap rate, the higher the risk and the lower the cap rate the lower the risk. That risk may be long-term impairment, tenant vacancy risk, repurposing cost risk if a tenant leaves, etc.
Let’s say you have two single tenant buildings both marketed for $1mm. One building has a Starbucks with a 20-year lease (18 years remaining) guaranteed by the Starbucks corporation (yes, THAT one). Its cap rate is 6%. The other has a local tenant with a 3-year lease and 1 year remaining. Its cap rate is 10%.
Now, the local tenant may turn out to be a great long-term tenant. Only your knowledge and research will help unearth that. But, the seller is implicitly stating with the higher cap rate that they believe there is tenant risk of default or vacating that is some level greater than the Starbucks building. Otherwise, if they were as confident as the Starbuck’s landlord, they’d price their building and income stream at a 6% cap rate, too. We know Starbuck’s is successful and the corporate entity can support the lease if they close the location. But, with the local group, we can’t be as sure.
So, the cap rate can help show you the inherent risk of a property.
But, what if your desired return is 20% on your equity? A 7.5% cap rate isn’t going to cut it. But, searching for a real estate investment with a 20% cap rate might well be a foolish and risky endeavor to your financial well being.
However, you can get there through leverage. Next week……