What does Cap Rate mean, really?

Question

Can someone please tell me in laymans terms what the cap rate is?  I've read definitions over and over, but I still don't get it.  Sorry feel like the dunce cap is on.

Natalie Schanne · Answer

@John S Lewis - Cap Rate is essentially your profit after expenses divided by the cost you paid for the asset. So, maybe your $100,000 property is expected to bring in $12,000/yr in rent (1% rule or $1,000/mo) but with all your property taxes, insurance, repairs, property management fees, vacant months (lower income), you only have $6,000 of profit in your bank account at the end of the year. Cap rate is that $6,000 of profit / $100,000 cost of the property = 6%. So, it is like getting a 6% return on your invested capital of $100,000.

When you have a loan, like 75%, you might consider a cash on cash return. You are collecting ($6,000 profit - cost of debt service) / 25,000 cash invested. This usually increases your return %.

The profit in real estate is called NOI or net operating income.

When you have a loan, like 75%, you might consider a cash on cash return. You are collecting ($6,000 profit - cost of debt service) / 25,000 cash invested. This usually increases your return %.

The profit in real estate is called NOI or net operating income.

Jon Holdman · Answer

@Natalie Schanne's description is correct, but the word "profit" is not commonly used in this context.  For real estate Cap rate = "net operating income" / purchase price.  Simple as that.  Her description is aligned with the real estate term "net operating income".

In business accounting, "profit" is used in three ways:  "gross profit", "operating profit", and "net profit".  Gross profit is the price you get for something less the cost of that something.  If I pay $60 for a widget and sell it for $100 my gross profit is $40.  That term is not really meaningful for rental real estate.  For operating profit, I then subtract the costs of running my business - marketing, sales, rent, office supplies, etc.  "Net operating income" is equivalent to "operating profit".  Net profit, aka "the bottom line" or "net income" then subtracts out interest and taxes.  That is truly how much the business puts in your pocket.  Real estate (and other businesses) also involve "taxable income".  That's operating profit less interest and depreciation, and is how you compute the tax to get to "net income".

Just to make things even more complicated, real estate often uses the term "cash on cash return".  Cap rate tells you your operating profit if you paid cash for a property. But since real estate is often financed, "cash on cash return" is (net operating income - debt service) / total cash invested often used to evaluate an investment.  This number is a good comparison to alternative investments since it evaluates, roughly, your return on the money you sink into the investment.

Notice that principal is included when calculating cash on cash return but not when calculating net profit or taxable income.  That's because its not an expense. Its a transfer of money from one account (your bank account) to equity in the property.  For commercial real estate (where you'll mostly commonly encounter cap rate) another common metric is "total return".  That accounts for equity building and is (net operating income - interest) / total cash invested.  Because commercial loans are often shorter than residential real estate the equity you're generating with the monthly payments can be significant.

Sorry, I got carried away.  I highly recommend What Every Real Estate Investor Needs to Know About Cash Flow... And 36 Other Key Financial Measures, Updated Edition by Frank Gallinelli.

Immanuel Sibero · Answer

So far cap rate has been defined as some measure of return of a specific property. But cap rate is more than just a measure of return. As a matter of fact it is a rather poor measure of return.

Consider another look at “cap rate” from a valuation perspective (i.e. also called “market cap rate” which @Brent Coombs casually mentioned above). As a valuation metric, cap rate is a measure of how many dollars of VALUE each dollar of NOI can fetch. Stated another way, cap rate is a rate that converts a dollar of NOI into x dollar of VALUE. For example, we all understand that when buying an apartment building we are essentially buying the income (i.e. NOI) of the property. But we also know that the property generates NOI every year. It is painfully cumbersome to pay the seller every year for the NOI that’s generated every year. Well there is a solution... Meet "Cap Rate". The established consensus is to apply cap rate to first year NOI to come up with a single value so a buyer can just pay the seller ONCE. This is known as capitalization. This is where the CAP (i.e. short for “capitalization”) in “CAP RATE” comes from. So cap rate is a rate that “capitalizes” or “converts” NOI into VALUE.

A quick google search of “cap rate”:

Investopedia defines cap rate as a return/performance metric.

http://www.investopedia.com/terms/c/capitalizationrate.asp?lgl=myfinance-layout-no-ads&ad=dirN&qo=relatedSearchNarrow&qsrc=6&o=40186

While Wikipedia defines cap rate as a valuation metric.

https://en.wikipedia.org/wiki/Capitalization_rate

For some reason Investopedia’s definition of cap rate is the one being perpetuated here on BP… maybe because it shows up first on the search.

Cheers... Immanuel

Jessie Niu · Answer

Cap rate is commonly used in commercial RE, but as Ryan D mentioned, it's fully capitalized rate of return as if there's no mortgage on it.

However, most of the deals are leveraged. I personally prefer cash-on-cash return and Debt Service Coverage Ratio (DSCR)

Brent Coombs · Answer

@John S Lewis, and just in case your reading hasn't stressed this point: "cap rate" is only relevant to commercial property (eg. buildings with at least 5x apartments), not residential.

eg. You could ask a Realtor: what is the local commercial market cap rate - for this area? Then you can hone in on how that compares with a specific commercial property in question.

[Note: For residential properties, value is determined by sold comps, not cap rate]. Cheers...

John S Lewis · Answer

Thx @Natalie Schanne

Giovanni Isaksen · Answer

For those who are stock market investors, cap rate in real estate serves as the common valuation metric just like a PE ratio (aka earnings multiple) does with stocks. Unlike PE though it's expressed as the inverse, so its closest analog in stocks is the earnings yield.

Why this is useful: An earnings multiple tells you how many years of earnings it will take to pay back your investment. In today's real estate market where cap rates are in the 5s, 4s and in Vancouver BC the 2s, it's pretty eye opening to see how long those payback periods are. 5% cap rate = 20 years, 4% = 25 years and 2% = 50 years... and that's just getting back to even!

Yes but some will say what about appreciation? Well if you bought something at a 2 cap how much further cap rate compression are you going to bet on? Virtually all future appreciation would only come through increasing NOI... and how long do you think that rents will go only up?

What does Cap Rate mean, really?

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