What is a cap rate?
A capitalization rate or cap rate for short is an answer to a fundamental question
that should be on the mind of every real estate investor.
For every dollar this property costs me to acquire
how much can I expect to receive back each year
in net rental income?
In short a properties cap rate is simply a ratio of its income divided by its cost or value.
It's a number that helps investors convert a property's income into value.
It's one way, but not the only way of measuring a rate of return for an income producing property.
The math behind cap rates is pretty simple.
It's net operating income divided by market value or cost.
Likewise, when you know what the cap rate is in any given market, you can also use this number
to calculate the value of a property by dividing the correct cap rate by your net operating income
net operating income divided by the cap rate gives you your market value.
Again, it's just the ratio of income over cost,
but both components in the equation warrants some further explanation.
In the real estate business net operating income
also known as NOI is the total annual income of property produces after vacancy and expenses.
In other words, it's simply gross rent minus expenses.
To determine the amount of gross rents
we start by considering what the subject property could generate in a perfect world
if it was a hundred percent occupied.
Then we subtract the anticipated vacancy rates.
So for example, if a property could generate a maximum of $10,000 per year,
but we expect it to have a vacancy rate of say 10%
then the most it can actually generate each year is $9,000.
Our next step would be to subtract the annual expenses.
This includes all of the anticipated items that will drain your bank account each year.
This could include things like property taxes, insurance, utilities, maintenance and repairs,
property management,
income taxes, HOA dues, and so on.
One expense that's non-included when calculating the cap rate is financing costs
such as a mortgage principal and interest payment.
Cap rates do not include loans or leverage in any capacity.
They analyze the raw income over the raw cost of a property because this number is not affected
by the financing terms of the deal.
Whether an investor buys a property for cash,
or they put 10% down or 25% down,
the cap rate will always stay the same regardless of the financing situation.
Now, when we say that the cap rate is NOI divided by market value or costs,
let's explain this a little further.
A properties cap rate can be calculated based on either
the current market value of the property,
the list price of a property
or the total cost you acquire it for.
And these three things aren't always the same number.
The property may be worth $700,000 in terms of market value.
But if you know that you can acquire it while covering
all closing costs and any immediate repairs for say $500,000,
then that $500,000 becomes the more relevant number to use
because that reflects the actual situation that you're in.
Ultimately the most useful way to calculate the cap rate is by starting
with the price you expect to pay for the property,
plus any additional cost required to close
plus any improvements needed to make the property functional.
And yes, that means factory in the rehab into the total cost.
Suppose you're able to buy a small apartment building all in for $500,000.
After doing your research and crunching the numbers,
you determined that the net operating income for one year will be as follows
$80,000 in annual gross potential rent minus 5% vacancy rate or $4,000
equals $76,000 in annual gross rent.
You also determine the annual expenses
look like $5,000 in property costs,
$3,000 in insurance,
8% or $6,400 in repairs and capital expenditures,
5% or $4,000 in maintenance costs,
10% or $8,000 in property management costs
for a total annual expense amount of $26,400
After subtracting the $26,400 of annual expenses from the $76,000 annual gross rent,
you'll have a net operating income of $49,600.
If we take this $49,600 amount and then divided by our total acquisition cost of $500,000,
we now have a cap rate of 9.92%.
Now that we understand the basics of how to calculate the cap rate
and what this number actually tells us,
let's talk about some of the pros and cons
to using this formula as the basis for analyzing a real estate deal.
A lot of people, especially in commercial real estate,
treat this formula as the golden standard to analyzing deals.
But now that you understand what this number is actually telling you,
you might see value in weighing in against other methods of analysis.
One of the major benefits to using cap rates is that they're a fast and simple way to estimate returns
on any particular property.
Cap rates are also a great tool to help you compare
two different properties with one objective measurement.
Imagine you have a choice between buying two identical properties across the street from each other.
If one offers you a cap rate of 7% and the other offers 9% and everything else is equal,
it would make much more sense to buy the property that's offering the higher cap rate.
But the simplicity of a cap rate provides both advantages and some limitations
By removing the interest in financing related costs from the equation
investors can use cap rates to compare
the raw income returns between two properties.
But financing is a huge component of making most deals work.
So don't assume that cap rates tell the whole story.
Another piece of the puzzle that cap rates ignore is the challenges that may arise
in property management and rent collection.
Two properties might have the exact same cap rate
yet one can be in an upscale neighborhood
populated by reliable residents with great credit scores.
And the other could be in a slum where late rents and defaults are the norm,
rather than the exception.
In summary, cap rates are a useful shorthand calculation.
You can do them on the back of a napkin in about 30 seconds
assuming you have accurate numbers available.
The simplicity of a cap rate makes it an easy metric to use,
especially when comparing returns
between two properties.
However, it's simplicity also means its usefulness is limited
and doesn't tell the full story about a property's returns.
If you found this video helpful,
you'll also like our videos that explain the cash on cash return and return on investment,
which are two other formulas that can help you get a more holistic look
at how good a deal might be.
For more tips, tricks, and real world guidance on how to crush it as a real estate investor
be sure to check out retipster.com to expand your real estate knowledge
and build your financial future.