Cap rates are more formally known as asset capitalization rates and are important for Boston real estate analysis. I’d like to shed a light on cap rates — and the way they are used when purchasing Boston condos for rental purposes.
Cap rates contain both positive and negative qualities, and while they can be invaluable in assessing risk, there are apparent shortcomings inherently built into this metric. The real take away here is the process in which you mitigate risk.
In Boston real estate, an asset’s capitalization rate or more simply, a cap rate, is a viewpoint of an asset’s return in a specific period when purchasing downtown Boston real estate.
The formula is quite elementary; you take the asset’s net operating income (NOI) and divide it by its value. In theory, the usefulness of a cap rate is very straightforward. A low cap rate indicates lower risk and increased value, and the higher the inverse, the more risk, and lower value.
The calculation you use to establish NOI is an integral part of the formula for setting the cap rate. Will you be focused on standard prognostications such as taxes, property management, and maintenance or variables such as vacancy and bad debt? The latter is increasingly more critical in a market affected by the coronavirus; however, there are at least a dozen opportunities to overlook and depend on unreliable estimates, adversely affecting your investment outcome. As you build your experience and thought process in evaluating risk, really consider the integrity of cap rates.
What creates the most significant value is the ability to focus on the property itself. With the exclusion of mortgage expenses, the cap rate formula allows you to compare one property/market to another. When evaluating the cap rate, you must analyze these factors:
Location: Typically, a great neighborhood has a higher market value, equaling higher rents.
Asset Class: Property type, such as single-family, multifamily, or other commercial properties.
Available Inventory: Supply and demand metrics in the market for the asset class of the property.
Regional Fundamentals: Population growth, employment growth, and inventory of comparables.
As with any new endeavor, you can take steps to mitigate risk by proper due-diligence and best practices. Seek honest and transparent Boston real estate professionals. When you realize that much of the underwriting you rely on to assess risk and future performance is forecasted, you must strive to understand the derivatives of their return conclusions.
Most importantly, study and research the Boston condo your buying. Does their risk tolerance align with mine? When relying on Boston real estate brokers, make sure to think about their motivations and whether they align with your interests. Also, do not forget that the data is already out there; self-education is a practice that should never be underutilized or forgotten. While it is vital to research, cross-reference, and verify the information you read, investing your time into acquiring further knowledge will be essential to your success.