Searching for your first investment property
When beginning your real estate investment journey, it can seem overwhelming at first. With phrases such as “Cap Rate”, “Cash on Cash Returns”, “Annualized Return”, “Gross yield”, and others, it can be difficult to make sense of property financial reports. Let’s break down each of these metrics and consider which ones you should focus on when looking at investment properties.
The first things many people will look at when searching for an investment property are:
1. Property appreciation
2. Monthly rental income
These are important metrics that give prospective investors a general sense of a property’s profitability. However, these metrics alone paint a very narrow picture. As an investor, it is vital to look at the full financial scope of a given property. This is where cap rate can be extremely helpful.
What is Cap Rate in Real Estate?
Cap Rate defined
Cap rate is calculated by dividing the annual net operating income by the purchase price of the property.
In other words, cap rate is expected annual cash return after accounting for things like property taxes, HOA fees, insurance, property management, maintenance costs, and other expenses related to the purchase and operation of your property.
Why Cap Rate is more important than Rental Income
The Cap Rate allows you to review the expected net annual cash flow of a property. While the rental income of a certain property may be higher, it does not always translate into a higher net ROI. This may seem counter-intuitive at first glance, but property taxes can vary wildly from neighborhood to neighborhood and city to city. Cap rate takes these often-overlooked costs into consideration, providing a more realistic estimation of annual returns.
An example
To help visualize this, let’s review two properties, Property A and Property B:
Property A:
Purchase price: $320,000
Rental income: $1,450/mo
Property B:
Purchase price: $113,000
Rental income: $1,100/mo
Upon first glance, Property A generates more gross income and therefore can seem more appealing. However, after factoring in purchase price and expenses, the picture shifts dramatically.
Property A:
Purchase price: $320,000
Rental income: $1,450/mo
Property tax: $3,900
Insurance: $110/mo
Net monthly income: $1,015
Cap Rate: 3.8%
Property B:
Purchase price: $113,000
Rental income: $1,100/mo
Property tax: $1,005
Insurance: $39/mo
Net monthly income: $977
Cap Rate: 10.375%
Although the gross income Property A generates is greater than Property B, after factoring in only property tax and insurance we can see that Property A brings in a significantly lower yield than Property B!
Cap Rate allows investors to quickly understand the net and compare the cash flow of different properties after factoring in expenses.
What is an Annualized Return in real estate?
An annualized return is the expected annual return on investment for a given investment property that is calculated by taking the expected cap rate plus estimated property appreciation.
Why Cap Rate is not a perfect indicator of expected returns
Although Cap Rate is a far better metric to review than simply looking at the monthly rental income, it’s important to review the appreciation of the property as well. Factoring in the Cap Rate and property appreciation is known as the Annualized Return.
Why Annualized Return matters
Let’s review two different properties again, Property A and Property B.
Property A:
Purchase price: $113,000
Net Rental income: $1,100/mo
Cap Rate: 8.4%Property B:
Purchase price: $124,999
Net Rental income: $1,100/mo
Cap Rate: 7.7%
If we view just the Cap Rate as discussed above, it seems that Property A is a better investment than Property B. While this is true when looking exclusively at cash flow, it doesn’t factor in appreciation, which can greatly increase the value of an investment over time.
Property A:
Purchase price: $113,000
Rental income: $1,100/mo
Cap Rate: 8.4%Property Appreciation: 1.3%
Property B:
Purchase price: $125,000
Rental income: $1,100/mo
Cap Rate: 7.7%Property Appreciation: 15.5%
Without doing some extensive math it may be difficult to see which is a better investment when factoring in Cap Rate and the Property Appreciation. This is where the Annualized Return will help you.
Property A:
Purchase price: $113,000
Rental income: $1,100/mo
Cap Rate: 8.4%Property Appreciation: 1.3%
Annualized Return 9.7%
Property B:
Purchase price: $125,000
Rental income: $1,100/mo
Cap Rate: 7.7%Property Appreciation: 15.5%
Annualized Return 23.2%
Although Property A’s higher cap rate may seem enticing at first glance, after factoring in appreciation the annualized return of Property B is over twice as high.
Balancing cap rate and appreciation
While cap rate and appreciation both contribute to the annualized return of a property, it is still important to consider both of these metrics on an individual basis.
Cap rate is cash in your pocket
During a real estate bull market, appreciation is often the driving force behind a property’s annualized returns. However, these gains are not realized until the property is sold. Additionally, appreciation rates can swing wildly from year to year depending on market conditions.
Cap rate, on the other hand, generates realized cash returns each month, and tends to be relatively consistent over time. Depending on your individual needs and risk tolerance, prioritizing cap rate may be in your best interest.
The boom-and-bust of property appreciation
While riskier and more speculative, chasing high appreciation rates can generate significantly higher returns than even the most efficient cash flow properties. During bull markets, median home prices can increase by more 20% annually, with specific markets appreciating even more. However, entering a bidding war in a hot real estate market can be a boom-or-bust scenario.
Properties in one of the USA’s hottest cities, Boise, are overvalued by an estimated 72% due to record demand. Investing in this kind of market, while potentially lucrative, puts you at a higher risk of getting caught on the wrong side of a correction. By failing to time the market properly, significant loss is a possibility.
Finding a balance
In many cases, high cap rates come at the expense of appreciation — and vice versa. High appreciation markets tend to have lower cap rates because property values are much higher. On the other hand, areas with extremely high cap rates can have sluggish rates of appreciation.
While the needs of every investor are different, finding a good balance between cap rate and appreciation is often the safest and most effective way to ensure a solid ROI.
Conclusion
In a hot real estate market where houses can sell within the same day of listing, it may be difficult to always choose the correct investment option available to you. It can be overwhelming to remember which metrics you should prioritize to maximize your returns and feel confident that you made the correct investment choice.
While there are many other factors to consider, understanding the key metrics highlighted in this post will go a long way in helping you make the correct decision for your real estate investment journey.
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