Real estate is my favorite asset class to build long-term wealth and passive income. Real estate is tangible, provides shelter, generates rental income, and tends to be much less volatile.
During the last financial crisis in 2009 – 2010, although the value of my San Francisco rental properties probably went down by ~15%, my rental income stayed steady because my tenants didn’t move. They kept on paying the same right through the 18 month recession.
Today, my SF rental properties are cash cows and their values have risen tremendously.
If you want to build wealth through real estate, you must own more than one property. If you only own your primary residence, you are neutral real estate because you have to live somewhere. Once you own a rental property, you are truly long real estate.
Defining The Cap Rate For Real Estate Investing
Every real estate investor should spend time thoroughly analyzing a rental property before purchase. Things such as rental income, occupancy rate, HOA reserves, area job growth, ongoing maintenance, insurance expenses, and pro forma future growth are all important.
One of the most important terms for all real estate investors to understand is the cap rate.
The cap rate is used to measure the return on real estate investment properties. When you’re considering multiple properties, it allows you to compare their earning potential at a glance. It also indicates how long it will take to recover the entire investment. This is also called the “payback period.”
While the rate is a useful tool for evaluating risk, it’s meant to be used as an estimate since there are many factors that can affect its accuracy. This will be one among many things to consider before fully jumping in on an investment property.
A cap rate is sometimes defined as the Net Rental Yield. In other words, how much rental income will you earn after all expenses.
How To Calculate The Cap Rate
To calculate cap rate, you take the net operating income (NOI) of the property and divide that number by its value. To get the final percentage, multiply by one hundred.
Net Operating Income is defined as Real Estate Revenue – Operating Expenses. Operating expenses include things such as maintenance, insurance, marketing, and HOA expenses.
NOI is a before-tax figure, appearing on a property’s income and cash flow statement, that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. When this metric is used in other industries, it is referred to as “EBIT”, which stands for “earnings before interest and taxes”.
Excluding the mortgage is very important in calculating the cap rate, because it allows for an apples-to-apples comparison on various rental properties.
The equation for calculation the Cap Rate = Annual Net Operating Income / Cost or Value Of Property
The cost or value of a property should include any applicable acquisition costs such as the brokerage or closing fees.
To calculate a cap rate, let’s say that a property is listed for $1,000,000 and generates an annual Net Operating Income (NOI) of $50,000. The cap rate for this rental property would be 5%.
The 5% can be considered a landlord’s annual return on investment. The landlord can then use the 5% to compare the cap rates for other properties he or she might potentially want to buy.
Determining A Good Cap Rate
A good cap rate is all relative to the risk-free rate of return (10-year bond yield) and the cap rates of other similar properties in your location.
In some places in the heartland of America, where I am very bullish on due to demographic trends, growing labor markets, and technology, you can regularly find cap rates for 8%+.
In other places like San Francisco, the cap rate goes down to as low as 2% – 2.5% because property values are so high compared to rents. In this situation, it’s actually economically better to rent than to buy. Given it’s much easier to invest in real estate now, you can rent an expensive property and invest your capital in higher cap rate parts of the country.
If you prefer earning income, then higher cap rate properties should be preferred. You always want to earn a higher cap rate than the risk-free rate of return given you are taking risk investing in property. The higher the cap rate above the risk-free rate of return, generally the better. Just beware that higher cap rates might indicate that principal appreciation is negligible.
If you are more interested in principal appreciation, buying in a market that has historically low cap rates might be a better indicator for what to buy. Cap rates in superstar cities like San Francisco and New York have been low for a while because they face international demand curves. Domestic and foreign investors are buying up properties in these cities because they have higher perceived value, much like a Ferrari has a higher perceived value than a Toyota.
Cities With The Highest Cap Rates
Take a look at the below cities with the highest cap rates. They are all situated in the heartland or in the south, where properties are much cheaper. You likely won’t get rapid capital appreciation like an internet growth stock, but you will get a steady income stream like a utility stock.
On the flip side, the lowest cap rates all come from bigger cities like San Francisco, Seattle, LA, Washington D.C., Boston where the cap rate range is between 2% – 5%. Here are my favorite cities to buy real estate.
Use Cap Rate As A Tool For Investing
Using the cap rate is a great way to screen real estate investment opportunities. Once you’ve got a good idea what the cap rates are, what they were, and what cap rate you want to pay, then you can proceed to do a deeper dive analyze of rental property.
Alternatively, you can invest in real estate through real estate crowdfunding platforms, which do all the research and vetting for you before allowing any real estate deal on their platform.
I’ve personally invested $810,000 in real estate funding since 2016 to diversify my real estate holdings and earn income 100% passively. I had sold an expensive SF rental property for a 2.4% cap rate and reinvested the proceeds into 18 commercial real estate properties across the heartland of America.
It feels great to no longer have to deal with maintenance issues and rowdy tenants, both of which I had for years. Fundrise is the best platform for all investors and CrowdStreet is the best platform mostly for accredited investors. Both platforms founded in 2012 and are free to sign up and explore.
I love utilizing technology and innovation to earn more and simplify my life. Below are examples of Fundrise properties.