If you’re familiar with residential real estate investment, terms like rental income, mortgage interest, and amortization are likely part of your lexicon. However, stepping into the commercial real estate arena introduces new terms, and one that’s often tossed around is “cap rate” or capitalization rate. For passive investors, understanding cap rates is essential, even if the nitty-gritty calculations are handled by others. In this guide, we’ll explore what cap rates are, how they’re calculated, their significance, and what you, as a passive investor with EquityNest, need to know about them in the context of real estate syndication.
What Are Cap Rates?
Cap rate, short for capitalization rate, serves as an indicator of the expected rate of return for a specific property. It’s a crucial metric for investors estimating the potential Return on Investment (ROI) for a given asset. When someone mentions a property having a cap rate of 5%, they’re essentially referring to the expected return on that investment.
Crunching the Numbers: How Are Cap Rates Calculated?
Cap rates can be calculated in various ways, so it’s important to inquire about the methodology. Typically, it involves taking the Net Operating Income (NOI) and dividing it by the market value of the property. Let’s break it down with an example:
Cap Rate Example
Consider a property valued at $1 million that generated $100,000 in rental income over the past year. After deducting $50,000 in expenses, the Net Operating Income (NOI) stands at $50,000. Dividing this by the property’s total value:
Cap Rate = NOI / Property Value
Cap Rate = $50,000 / $1,000,000 = 5%
This implies that if you were to buy the property for $1 million, you could expect a net income of $50,000 over one year, loosely representing your ROI.
The higher the cap rate, the quicker you’d recoup your investment. However, as a passive investor, you don’t need to delve into the specifics, but a basic understanding proves beneficial.
Deciphering Cap Rates: How Are They Used?
Some investors heavily rely on cap rates, seeking investments with rates of 8% or higher. However, it’s crucial to recognize that cap rates are just one data point for a specific year and don’t account for factors like loans or the time value of money. They are particularly useful when comparing different properties in the same market.
Cap Rates and Risk Assessment
Cap rates offer a general measure of the asset class and associated risk. Higher cap rates are often associated with developing areas, while lower rates may indicate more established locales. As with any investment, higher rates correlate with higher risk.
What EquityNest Passive Investors Need to Know About Cap Rates
Now that you have a foundational understanding of cap rates, how they’re calculated, and their use, you might wonder about their relevance as a passive investor with EquityNest.
#1 – Comparable Cap Rates
A reliable sponsor team, like those at EquityNest, will have already evaluated the property to ensure its cap rate aligns with others in the area. However, it’s prudent to verify that your property’s cap rate is reasonably comparable to others in the vicinity.
#2 – Reversion Cap Rate
Introducing a nuanced term – Reversion Cap Rate, sometimes referred to as the exit cap rate. It measures the cap rate at the sale of the asset compared to the cap rate at the time of purchase. When assessing a potential real estate syndication deal, ensure the reversion cap rate is at least 0.5% HIGHER than the current cap rate. This conservative underwriting indicates an acknowledgment of potential market softening in the coming years.
Cap Rates – A Final Perspective
In conclusion, cap rates provide a snapshot at a specific point in time, reflecting the current performance of a property. They don’t predict an asset’s potential or the extent of distributions. As a passive investor with EquityNest, while understanding the terminology is beneficial, cap rates are among the least of your concerns. Focus on vital data points, with the track record of the sponsorship team taking precedence in your investment evaluation. Your journey into real estate syndication with EquityNest is guided by comprehensive insights and a supportive team, making your investment experience seamless and rewarding.
