What are cap rates and how do they work? How can I use cap rates to help me find a good real estate investment? Here we’ll discuss the role cap rates play in real estate investing and what other factors are important to consider.
What is a cap rate?
A cap rate (or capitalization rate) determines the rate of return that you can expect to come from a real estate property. This helps the potential buyer decide if the investment will be profitable enough compared to the market price.
A cap rate is a great way to compare the profitability of properties with different market values. Say you’re looking at two different apartment buildings. While one is listed at $900,000 and the other at only $750,000, the more expensive property’s rent prices and building condition might make it a profitable investment even at the higher purchase price. Calculating the cap rate makes it easier to compare the properties with these factors in mind.
How are cap rates determined?
The simplest way of finding the cap rate of any property is to follow this formula:
Annual Rental Income - Annual Expenses = Net Operating Income (NOI)
NOI / Purchase Price = Cap Rate
The NOI is calculated by taking into consideration all mandatory expenses that come with the building: taxes, maintenance and repairs, vacancy, and other expenses. Note that the NOI does NOT include mortgage payments. This can be beneficial for your calculations because it shows the objective profitability of a building regardless of how you plan on financing it.
Using cap rates for real estate investing
Cap rates are usually the biggest deciding factor for investors when it comes to commercial multi-family units. But how are they best applied? What are good cap rates?
Depending on the city where you are looking to invest, cap rates change and mean different things in terms of a property’s profitability. While a higher cap rate will generate higher income, it also comes with higher risk. A lower cap rate implies a lower annual profit but might provide better security.
A cap rate also helps you understand aspects of the property’s neighborhood value. In Chicago, the 2019 average cap rate for Lincoln Park was 4.02%. In Humboldt Park, the average was 7.97%. This shows the difference between commercial multi-families in established areas and cap rates for up-and-coming neighborhoods. Note that these numbers might vary depending on the study since there are different ways to determine NOI’s and property eligibility.
What is a good cap rate for Chicago real estate?
Chicago cap rates bring good news for real estate investors: at a 4.13% average, the city boasts higher rates than the 4.03 national average, making it a great place to search for an investment. Unfortunately, the simple answers end there. Chicago cap rates vary from neighborhood to neighborhood. While a 6.0% cap rate might look barely above average for one area, it might be an excellent investment for a well-established neighborhood where most cap rates are lower. It all depends on what you’re looking for.
What cap rates don’t cover
- Market Trends: While cap rates do change across different neighborhoods, they don’t always provide a concrete picture of how a building might increase or decrease in property value over the next few years. In Chicago, where neighborhood values fluctuate quickly, it’s important to take cap rates with a grain of salt and consider other factors at play in the area. A building with a low cap rate that doesn’t look profitable might be located in an up-and-coming neighborhood and will increase in thousands of dollars in value over the next few years. If you only search for buildings with a certain cap rate or higher, you risk missing out on that kind of opportunity.
- Financing: As we mentioned before, cap rates don’t take your financial planning into account. This is beneficial when comparing properties, but the cash profit you make is going to be dependent on how much of the gross rental income needs to go to your mortgage each month.
Using cap rates for residential multifamily
While cap rates are a crucial part of determining property value for commercial multi-family investors, residential multi-families qualify for unique benefits that should be considered in addition to the property’s cap rate. Even if a two-flat in Irving Park only has a 5.5% cap rate, it has advantages over a commercial multi-family that aren’t reflected in that percentage.
Because residential multi-families fall in a similar class as single-family homes, your lender will charge you a lower overall interest rate on your mortgage if you claim owner occupancy. This is an option that’s not available for properties with 5 or more units. In the long run, this saves you thousands of dollars in interest that aren’t reflected in a cap rate.
Owner occupancy also allows you to offset your living expenses. Although most investors don’t choose real estate simply for this reason, it’s important to remember the benefits that come with not having to pay your own rent while other rented units cover the cost of the building’s mortgage. While this approach doesn’t look as profitable from a cash flow perspective, it helps you cut down on your monthly costs if you’re open to living on your property.
Cap Rates for Multi-Family Investments
A cap rate is a great tool to get you started on the path to a smart real estate investment. It helps you compare properties and understand more about their potential to bring in profit. Cap rates will also help you narrow down what kind of real estate you’re ready to invest in, whether it’s a lower risk property with market stability and lower-income or a higher risk building with renovation potential.
Remember to consider the bigger picture, especially when using cap rates to find residential multi-family properties. Market trends and your plan to finance the property both play big roles in what kind of return you can expect to see on an investment.
Questions about buying or selling an investment property?
If you have more questions about how to use cap rates to help determine your next real estate investment, contact Jose Hernandez or check out our search tools to see residential or commercial multi-family listings throughout the city. We have been working in the Chicago multi-family market for years and would love to help you find your Chicago real estate investment property.