In real estate, we often hear that the three most important aspects of a property are location, location, location. While those three “rules” may apply when purchasing your dream home, there is another, possibly more important, factor to consider when purchasing an investment property. Capitalization Rate Valuation, or “Cap Rate” is a calculation method of estimating potential cash flow for a property, not simply how much the property might be worth.
To calculate the Cap Rate (expressed in percentages), divide the Net Operating Income by the Price or Value of the property.
For example, if the Net Operating Income (NOI) is $2,000, and the asking price is $100,000, the Cap Rate is 2%. Going further, the Cap Rate can estimate when a property can be fully capitalized (pay for itself). A 2% Cap Rate will take 50 years to capitalize, a 5% Cap Rate 20 years, etc. Obviously, the higher the Cap Rate, the better the investment. What is a “good” Cap Rate? A good Cap Rate depends on the return you are willing to accept for the risk you are taking. Also, what might be a good Cap Rate in San Diego, may be different in Orange County.
While a Comparative Market Analysis (CMA) values a property based off sales of similar property with similar physical characteristics, Cap Rates aren’t determined or affected by comparable properties.
Using the CMA method, the value of the property can be swayed by what a less-sophisticated investor was willing to pay on the last deal. Similarly, property located in prized areas are typically bid up to higher prices based off emotions. Moderately priced properties, in nondescript locations tend to have higher Cap Rates than their prized location counterparts. Here in San Diego, depending on which report you read, the Cap Rate is approximately 6%. Coastal areas were .5 to 1% lower, and inland areas were about 1% higher.
As a San Diego property management company, we’ve noticed that many of our clients that own multiple investment properties tend to stick with the less-glamorous neighborhoods. While these properties may not make the cover of Home and Garden, they do provide great cash flow for the owners.