Cap rate is an American term and provides an interesting alternative measure for commercial real estate investment. It’s growing in popularity in the UK as a quick measurement that calculates returns when costs are deducted from income but when a mortgage is not applicable or has yet to be found.
Cap rate is best understood by comparison to net yield.
Net yield is calculated by:
Annual Rental Income – Costs/Purchase Price or Value x 100
Costs here include everything from maintenance charges to mortgage payments.
Capitalisation rate is calculated in the same way:
Annual Rental Income – Costs/Purchase Price/Purchase Price or Value x 100
What’s The Difference Between Net Yield And Capitalisation Rate?
The difference is, costs used to calculate the cap rate do not include mortgage payments. Essentially, then, cap rate gives you the returns expected from an all-cash purchase.
Cap rate is a hybrid between net yield and gross yield. Normally, we might simply divide rent by price to get a very rough indication of how good a commercial real estate investment might be. Cap rate improves upon this by factoring in yearly costs whilst swerving mortgage payments which are not always readily available to use in investment calculations.
This allows you to compare investment opportunities between different properties and classes without fiddling around with the unknowns of mortgages. It’s a rough figure shows you how costs and their associated risks might affect your early investment decision-making.
For example, you could compare the cap rate of an HMO building with higher maintenance costs but also higher rent to that of a house with lower maintenance costs but lower rent. Cap rate bakes costs into a rough measurement that doesn’t require mortgage payments to provide a meaningful comparative figure.
Rent is usually fairly straightforward to research, especially in the case of researching a building currently on a lease that you plan to buy. In this case, the rent will remain the same or change negligibly, so long as the building and its use class remains consistent, i.e. you don’t plan on making any major changes.
Monthly rent is added together to get yearly rental income.
Let’s say a £240,000 flat is rented for £1,000 a month, giving an annual rental income of £12,000.
We then need to find all associated costs. First and foremost, you need to apply any property management costs which could be around 10% of the rent, so £1200 in this example. Maintenance and repairs costs are fairly easy to estimate, though you’ll need to bear in mind that one year you might need to carry out no repairs whatsoever whereas another year the boiler might fail to incur major repair costs.
Maintenance costs will vary a lot between buildings also; their age, any listed status, and their intended use. Higher risk = higher potential costs and vice versa. Ensure your costs reflect the risks entailed by the building. This is where cap rate excels, it can show us how riskier and higher costs can impact our returns.
Overall, for this example, you might come to a figure of around £10,000 net income when deducting all costs bar mortgage payments from the yearly rental income.
To get the cap rate, divide this by the cost of the building and times by 100 to form a percentage:
£10,000/£240,000 x 100
= Cap Rate of 4.16%.
You can then compare this cap rate against other investment products, buildings and savings accounts. A higher cap rate is not always better if risks are also high, but you should always try and factor risk into your costs.
There are some obvious limitations here. Firstly, it’s hard to estimate costs accurately for some buildings. Also, you may be planning on major renovation work which would render cap rate a fairly useless measure of comparison between buildings with vastly different renovation costs. At some point, you will obviously have to involve any mortgage payments and find a more accurate ROI figure. Despite this, cap rate provides a quick comparative figure that gives some indication of yield when costs are factored in, but when a mortgage is not required or yet to be specified and researched.
Cap rate can be used to determine what price you might bid for a property.
For example, you’re researching the particular building used in the example and know you want to ideally obtain a cap rate of 5%. You know the net income is around £10,000, as we worked out previously. Here, you can divide this net income by your desired cap rate and times by 100 to obtain the price you’d need to pay to obtain your desired cap rate.
Net income (£10,000)/Desired cap rate (5%) x 100
This produces a figure of £200,000, way below the £24,000 asking price of the building. If you want to obtain a cap rate of 5% then this building is overpriced.
Here, we can see the strengths of using cap rate to quickly crunch basic and readily available numbers for commercial real estate investment. They provide a snappy way to bake in property costs without fiddling over true ROI calculations that require mortgage information.
Cap rate may output a relatively small figure compared to other investment products when taken on its own. However, you have to bear in mind that long term returns can increase dramatically in value if a building rises in value. You may be prepared to invest in a building with a lower cap rate if you feel it is strategic in the long term, e.g. if the area is pending development or you think rent can be increased following some small renovations.
Risks may also be negative, e.g. tenants and whether or not they are able to fulfil rental payments consistently throughout their lease, whether your building maintenance costs could increase dramatically, market fluctuation and other environmental and socioeconomic factors. A lower cap rate may be fine for a lower risk investment for if you’re taking extra risk on board, it’s best to look for higher cap rates.
When you calculate costs, it’s beneficial to think in terms of risk and probability. Maintenance and repair costs especially will be very low for newer buildings but for older buildings, you should be realistic about quite how much they could impact your ROIs and yield. Cap rate allows you to incorporate an element of this risk – you simply increase the value of the estimated costs.
Overall, cap rate is useful for bringing costs into the frame without mortgage costs. This allows you to make quick comparisons between similar buildings. A low-risk property investment might be presented with a lower cap rate whereas high-risk investments, whilst they have attractive cap rates, are prone to greater volatility. Fundamentally, though, cap rate ensures we are factoring costs and their attached risks into our calculations rather than looking exclusively at returns.