As a prudent investor risk is always on our mind, especially given the current market environment. Before delving into any investment, we must fully understand the risk involved. The best way to understand the level of risk we are going to take on is by quantifying it. When we do that, we can compare investment opportunities to take advantage of the investments with the highest risk-adjusted return. In this article I’m going to outline one of the simplest ways to measure risk in rental properties and how to choose the best investment that will produce the highest rate of return with the least amount of risk.
Understanding risk
First, we need to define risk. In financial terms, risk is the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Because of risk we may not only produce less gains, but we may actually lose some or all of our investment. When analyzing an investment opportunity many new investors tend to focus only on the possible gains from the investment and tend to ignore the potential downside loss that an investment may bring. Even seasoned investors have overlooked investment risk at times and ultimately faced significant losses - think Bear Stearns and Lehman Brothers in 2007.
Each asset class has different ways to measure risk. For stocks, investors typically use the standard deviation of historical prices, which provides a measure of price volatility in comparison to its historical average price. A high standard deviation indicates a lot of volatility meaning the stock has a high degree of risk. Real estate investment risk cannot be measured using price volatility since real estate is not traded as frequently as stocks are. For the real estate asset class, the most common risk measure is the capitalization rate (cap rate).
Calculating the cap rate
The cap rate is defined as the ratio of a rental property’s net operating income (NOI) to its original purchase price or estimated current value (including any initial repairs). The cap rate can be used on an individual property or on an entire market by comparing the average cap rate for a large group of properties. To generate a cap rate of an entire market we would need to perform some research to estimate an NOI for the market. Here is the formula for cap rate:
The reason the cap rate is such an essential tool for analyzing risk in properties is because the cap rate does not consider any mortgage expenses. Since the cap rate only focuses on the property and not the financing involved, we can better compare investments. When purchasing a property, investors have the ability to finance the property with all cash or some combination of financing. The cap rate assumes that the property was purchased with all cash and lets us compare the risk of one property or a market to another.
Let’s take a look at an example with numbers very similar to a property that we currently own:
• Suppose we are interested in purchasing a single-family residence where the current value is $100,000.
• The net operating income is our gross income minus operating expenses. The operating expenses include any property management fees, HOA fees, taxes, insurance, and so on, but no financing related expenses.
• Let’s assume you will self-manage the property. The current gross monthly rent is $1,200 for comparable properties. With some research you determine the monthly operating expenses would be $400. This generates an annual NOI of ($1,200 - $400) x 12 = $9,600.
• Next, we divide the NOI by the property’s value to get the cap rate. For this property the cap rate is $9,600 / $100,000 = 0.096 or 9.6%.
• Now we can use this cap rate to compare similar properties to determine the best investment for the level of risk we are willing to take.
Measuring risk with the cap rate
Real estate investors use the cap rate as a measure of risk. So, in theory, a higher cap rate means an investment is riskier and a lower cap rate means less risk. Each investor has their own unique risk profile. That is, only they can determine the level of risk they wish to take on and what will let them sleep soundly at night. Before taking on a new investment, it’s important to determine the level of risk you are willing to accept as opposed to first thinking of how much profit you desire from an investment. Once you determine the level of risk you are comfortable with you then need to determine if the investment will deliver the proper amount of return for the amount of risk you are taking on; i.e., risk-adjusted return.
More risk, more reward
There is a fundamental idea in finance that there is a direct relationship between risk and return. Since we are prudent investors, as we take on more risk we should be rewarded with a higher return. We can use the efficient frontier method, which is an idea from modern portfolio theory, to determine the investment that offers the highest return for a defined level of risk.
In general, the higher the cap rate, the riskier the investment. A high cap rate means your asset price is low, which could lead to a risker investment relative to other investments with lower cap rates. Comparing cap rates with other properties in the area can help to determine what’s the best investment relative to risk.
Location plays an important role in cap rates. This is because each market has a unique set of factors that affect the cap rate such as economics and demographics of the market, the area, and the types of properties in the market. An urban market that is booming will have a different cap rate than an established rural or suburban neighborhood that is no longer expanding.
In the graph below, we have 5 different hypothetical investment opportunities. The x-axis is our level of risk represented by the cap rate and our y-axis is our potential return represented by the cash-on-cash return ratio. Notice how property A and C both have similar levels of risk, but property C produces a significantly higher rate of return. Therefore, according to modern portfolio theory, we should choose property C over property A. Also, notice that property E has the highest potential rate of return around 12%, but it also has the highest level of risk. Simply choosing an investment because it can potentially produce the highest rate of return and ignoring the amount of risk involved is not prudent. Property E has about 31% more risk than property C, but only generates about a 17% better rate of return overall. Keep in mind that in this example we are simply comparing two ratios to make an investment decision. As a real estate investor, it’s important to understand the local market fundamentals you are investing in and ultimately make an investment decision using a holistic approach and not just off of one metric.
Conclusion
Cap rates are an important risk measure when analyzing properties. But since each investor has their own risk tolerance, it shouldn’t be your only indicator. Cash flow, the type of market and many other factors, the type of market and many other factors should be considered when making an investment decision. A higher or lower cap rate for one investor may be more desirable than another and the same goes for the rate of return. So, if a property hits most of my criteria but falls a bit short of my cap rate goal, I wouldn’t pass up on it only for that reason. Nevertheless, the cap rate is one of the most important ratios for any investor when analyzing properties and will provide great insight to the level of risk involved in the investment.