April 29, 2024 | Reading Time: 2 Minutes
If an investor is considering what to look for in a real estate investment, a cap rate is one of the first factors they review. They want to know their return before debt service (the mortgage). You can find the cap rate by taking the net operating income of a property and dividing it by the purchase price.
When looking at cap rates, keep in mind that these figures are sensitive to changes in the market. It can be helpful to consider other trends that could impact the cap rates in your area. Remember to keep in mind when you research properties and think about their potential returns.
Cap Rates & Interest Rates
If you look at cap rates for different properties, keep in mind that these figures are very sensitive to interest rates. As mortgage rates have rates have gone up during the last years, so have cap rates. Investors today are typically looking for positive leverage. That means that the rate they are borrowing at is at the same level as the cap rate, or less.
Back in the early in the 2000s, some investors would actually accept a lower return than what they were borrowing for. They did this because they hoped they could make up the difference by increasing the net operating income. In other words, they felt that the upside would offset this. Unfortunately, that didn’t’ play out in some scenarios, as property values didn’t increase and investors had to pay high rates on their debts. They were unable to exit out of the property and many went bankrupt during the crash of 2008. Today, investors seem to have learned from these past instances and tend to look for positive leverage.
Establishing Your Returns
If you take your net operating income and subtract your debt service, that will establish your cash flow. If you divide your cash flow by the amount of equity you have in the deal, that will be your cash-on-cash return. If your debt service is less than the cap rate that you are buying at, you will see that your cash-on-cash return will be higher than the cap rate.
Once you know the cap rate of a place, along with how it is determined and the trends in the market, you’ll be able to get a better sense of the return you can expect. You’ll want to pay attention to your tolerance for risk, too, and take steps to make sure you’re not overleveraged. Overall, working with an experienced team can help you get the information you need to make an informed decision on an investment property.