What Is Capping in Real Estate Investments?

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Written By Justin McGill

DealBloom aims to share the latest tips and strategies to help realtors, brokers, loan officers, and investors navigate the world of real estate.

As a real estate professional, it’s important to understand what is capping in real estate and how it can affect your business. Capping refers to the maximum amount that a lender will allow a borrower to spend on closing costs. This includes things like appraisal fees, loan origination fees, and title insurance premiums. Closing costs can vary depending on the type of property being purchased and the location of the property.

What Is Capping In Real Estate?

Capping is a method used by some real estate investors to limit their downside risk. It involves setting a maximum price that you are willing to pay for a property and then only bidding up to that price.

If the property sells for more than your cap, you simply walk away.

What is capping in real estate? Cap rate is a key metric in real estate that measures the profitability and return potential of an investment.

The capitalization rate is the yield on a property over a 1-year period, assuming that it is bought with 100% cash and is not financed.

How Interest Rates Affect Cap Rates

You may have noticed that interest rates have been in the news lately. This rate is also known as the fed funds rate and it affects other lending and borrowing rates and caps.

Local market factors, such as local economic indicators, demographic trends, and other micro-criteria, have the greatest impact on your real estate investment.

Interest rates play a significant role in real estate values because they affect debt financing and national capital markets. As interest rates change, it can cause cap rates to increase or decrease, even if the property or market remains the same.

Let’s assume, for example, that a $1 million property is being sold at a 6.48% capitalization rate and that the overall interest rate for the economy goes up to 7.5%.

With the same net income, the property value would be $864,000 ($64,800 / 7.5%). That’s a $136,000 or 13.6% decrease with no changes in the fundamental value of the property itself!

Now, will that actually happen? Perhaps.

But not necessarily.

The correlation between interest rates and cap rates is not always linear. A change in interest rate does not guarantee a shift in the cap rate.

Although a perfect correlation does not exist between interest rates and cap rates, they have generally moved in the same direction in the past.

But the relationship between interest rate and the cap rate is a warning that your location, income, and your debt situation should be strong enough to survive any upcoming economic shock.

Are High or Low Cap Rates Better?

A cap rate is the measure of the risk associated with an investment.

A higher cap rate indicates a higher level of risk for an investment, while a lower cap rate means the investment is less risky.

What’s a Good Cap Rate for Rental Properties?

Which investment property would you purchase? Would you go with Property 1 which has a 6.35% cap rate or Property 2 with a more risky but more profitable 8.40% cap rate?

A “good” cap rate will depend on your personal investment criteria and preferences.

Property 1 would be a good fit for investors with more stable experience. With its solid location and positive future outlook, it could even be more profitable over time.

Property 2 would be a good fit for the more entrepreneurial investor. The potential returns are bigger if everything goes well, but there is also potential for lower returns or even losses.

I’m the type of investor who would take a bit more risk for the potential of higher returns. I bought a property similar to Property 2 a few years back and it turned out very well.

But I can see where investing more in Property 1 could also be a good idea.

When is a Cap Rate Helpful?

The capitalization rate is a very helpful tool when you’re analyzing an investment property that yields steady, consistent returns. For instance, if you’re looking at a quadruplex that houses long-term renters, you’d calculate the cap rate for that.

When you’re looking at potential investment properties, it’s helpful to calculate and compare the cap rates. This will give you an idea of which property is a better addition to your portfolio.

When you’re trying to decide between two properties, the cap rate can be a helpful tool in determining which one is a better investment. For instance, if you’re looking at two duplexes in the same downtown area, and one has a higher cap rate than the other, it may be a better addition to your portfolio.

If you know the potential investment’s cap rate, you can determine if the asking price is reasonable. If the property is overpriced based on your calculations, you may be able to negotiate a lower price.

When is a Cap Rate Not so Helpful?

If you’re looking to flip a property or offer it as a vacation rental, calculating the cap rate may not be particularly useful. However, if you’re planning to rent it out on a short-term basis, knowing the cap rate could be helpful in determining your potential return on investment.

One of the goals of flipping a property is to minimize the amount of time it is held onto – making the cap rate’s 12-month frame of reference less useful.

For vacation rentals, you’re likely to encounter income fluctuations and changes in operating costs, such as maintenance costs, as tenants come and go.

These factors can make it difficult to accurately calculate your net operating income, and as a result, your cap rate may not be as reliable.

The cap rate is calculated based on the assumption that you’re buying the property all cash, not borrowing any money. So, it doesn’t take into account the costs involved with getting financings, such as interest payments or loan origination fees.

How to Calculate The Cap Rate

Calculating the cap rate is simple enough, but there are multiple ways to do it. We’ll go over the most popular method below.

Cap Rate = Net Operating Income / Current Fair Market Value

Let’s break each component down.

Net operating income: Your net operating income is your gross rental income minus your operating expenses. To calculate your net operating income, you need the following information:

  1. Gross rental income: Multiply the monthly rent for the entire building by 12 to get the annual rental income. If the property has no tenants, determine the rent rate for similar buildings in the area.
  2. Operating expenses: real estate taxes, utilities, liability insurance, and maintenance
  3. Subtract operating expenses from gross rental income to determine net operating income.

Current fair market value: You can use either the asking price or the price you’d offer.

You’re considering a house that costs $325,000 and the current renters are paying $2,000 a month.

The gross annual rental rate is $24,000.

You anticipate that your annual operating expenses will be $5,800. This includes $3,800 in property taxes and $2,000 in maintenance and other expenses.

Therefore, your net operating income is $18,200.

To calculate the cap rate, you will need to divide the net operating income by the property’s current fair market value. In this instance, we will use the list price of $325,000. This would give you a cap rate return of 5.6%.

If your estimates are correct, this two-bedroom property would give you a return of 5.6% when using the cap rate method.

Assuming that you are receiving full rent each month and that your tenants keep up with the rent, the property is likely to be 100% occupied 365 days a year.

While a single-family home might experience 100 percent occupancy, it’s much less likely for multi-unit buildings with more tenants.

So, whenever possible, you’ll want to account for a less-than-100% occupancy rate when calculating your cap rate.

Let’s adjust the formula for calculating net income to:

Net Operating Income = [(Gross Rental Income) x (Occupancy Rate)] – (Operating Expenses)

Most investors anticipate a 5% to 10% vacancy rate when making projections. So, if you were to project a 90% occupancy rate in the above example:

Net operating income = [($24,000) x (.90)] – $5,800 = $15,800.

Cap rate = $15,800 / $325,000 = 4.9%.

When you consider reduced occupancy, the two-bedroom house now has a cap rate return of roughly 4.9%, making it a slightly less attractive investment.

Conclusion

What is capping in real estate? When it comes to real estate, the capitalization rate is the most widely used metric for gauging the profitability of a real estate property. The cap rate is the yield on a property over one year, assuming that it is bought with cash and is not financed.

Justin McGill