Why do you exclude the mortgage payment from the cap rate?

Question

It seems like you would want all expenses included right? As I understand it the cap rate is telling you what percentage of the total price you'll make back in a year?

So why would you exclude the mortgage payment because that IS an expense.

Paul Bowers · Answer

I would assume it's because everyone's mortgage payment will be different so it would render the cap rate number useless.  I may put 50% down and do a 30 year note.  You may put 10% down and do 15 years.  That generates a huge difference in payment so we'd come up with dramatically different cap rates based on all other numbers being the same.  By basing it on a cash purchase it comes out the same for everyone.  You obviously need to count the mortgage expense in your numbers but using cap rate gives you a way to compare properties with no mortgage cost variable.

Russell Brazil · Answer

Everyones borrowing terms are different, and the method you borrow at has nothing to do with the property.

Matt K. · Answer

Not everyone will have a mortgage payment...

Thomas W. · Answer

Thank you all for the responses! This makes perfect sense now, cap rate is a method to compare properties not determine your ROI.

Steve Vaughan · Answer

Cap rate is just the rate at which NOI 'recapitalizes' your purchase price.  If you kept every cent of NOI, how many years until you get your PP back?

If it takes 15ish years of NOI, your cap rate is 6ish on the crude level we're discussing.

Debt service is not part of NOI.   From your NOI, you subtract debt service and cap ex to get to net CF though.

Richard Sherman · Answer

Cost of debt is not an indication of the performance of the property.  An example is what if I own the property free and clear, my cap rate would be much higher than someone with a loan if it was included in the cap rate, but that tells us nothing about the underlying property.  I am trying to make it understandable and not just a technical answer  :)

Why do you exclude the mortgage payment from the cap rate?

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