The tangibility of real estate can lead some investors to falsely believe that all real estate investments are “safe.” The allure of growth plus income, combined with historically beneficial diversification to traditional stock and bond portfolios, has made real estate an incredibly attractive investment for doctors for decades. While many doctors swear that real estate is the only way to accumulate income and prepare for retirement, they often overlook the expense of an investment in the interest of focusing on gross income.
This is why one of the key concepts of investment real estate must be considered: capitalization rate. This metric is essential to evaluating the income productivity of a piece of real estate, a portfolio of real estate, and/or a real estate investment trust (REIT). The capitalization rate, or “cap rate,” is the percentage that reflects the net operating income divided by the value of the property. For instance, assume a building generates a gross income of $100,000, with $60,000 in expenses. If the building is worth $1,000,000, then the cap rate is 4% [($100,000-$60,000)/$1,000,000].
What does the cap rate provide? For starters, it gives a good comparison of a real estate investment to other classes of investments. If a treasury yield is 2.5% and the cap rate for a piece of real estate is 4%, an investor has the opportunity to evaluate the difference between the risks of each of those investment opportunities and ultimately determine whether the risk is worth the premium. The cap rate can also be used to determine whether or not one should exit a property due to appreciation of value without an opportunity to increase rent. Cap rates also help to identify trends. If a doctor is looking at a market in a given geographic area, cap rates can help provide an understanding of relative value compared to historical figures.
It’s important to note that there is no inherently good or bad capitalization rate, just like there are no inherently good or bad returns on other investments. Rather, the return of the property is situationally dependent and varies based on risk, which includes the length of tenant leases, the industry and diversity of tenants, the age of the property, socioeconomic conditions of the building location, and community trends around the building’s location.
A few caveats
There are a few caveats to consider. First, mortgage expenses are not considered when calculating net operating income. The mortgage is used to pay for the property, and the interest expense is a cost of acquisition, not a cost of operation. Often, capitalization rates are artificially low when calculated by novices due to this error. Additionally, this calculation does not include growth of the asset; this would be reflected in an internal rate-of-return calculation (IRR). While both calculations are important, a strong entrance cap rate can limit some of the downside risk for a piece of property, and as a result, it’s the first place a prospective investor should begin. Comparing the two calculations can provide insight on the growth component of the investment and allow the potential investor to evaluate the risk for each component.
While a capitalization rate calculation can be very helpful to provide a general sense of a piece of real estate, nothing can substitute for getting specific advice for a property. A potential investor should consult with an accountant, commercial real estate agent, or investment advisor before making a decision about property. Ideally, all three advisors should be included in such an instrumental decision. However, cap rate is the first thing a doctor should understand when considering a potential piece of real estate. This will provide a preliminary understanding of the upside of the investment before contemplating potential growth in the value of the property.
ANDREW TUCKER, JD, CFP, CPA, CIMA, and JOHN K. McGILL, JD, MBA, CPA, provide tax and business planning for dentists and specialists. The McGill Advisory newsletter is published through John K. McGill & Company Inc., an affiliate of the McGill & Hill Group LLC. It is your one-stop resource for tax and business planning, practice transitions, legal, retirement plan administration, CPA, and investment advisory services. Visit mcgillhillgroup.com or call (877) 306-9780.