Cap rate explanation for sfh

[Delbert Standifer]

Greetings everyone, my question is can someone easily explain cap rate for sfh?

[Kevin McGuire]

@Delbert Standifer , your post has an automatic link to the formal definition,

“The capitalization rate is the rate of return an investor can expect from an investment in real estate, assuming they pay all cash. “

I'm not sure if you're asking how it applies specifically to a SFH so let me know if I didn't get your question and apologies if I'm explaining something you already understand.

Normally cap rate is used for commercial properties but I use it to analyze my SFH rental purchases too. Think of cap rate as a dividend yield. To analyze a purchase, you take the annual rental income, subtract all the expected operating expenses (taxes, HOA fees, maintenance, utilities, etc.) and divide by the purchase price. If you're going to net $4,000 on a $100,000 property it'll have a cap rate of 4%. It's helpful for comparing properties you're considering buying since it tells you how effective each property will be at generating net income. It doesn't take into account financing charges though since that's not an operating expense but is really a cost of money for being leveraged.

For residential, folks tend to use Cash on Cash (CoC). Wikipedia defines it as, "the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage." It does take into account the mortgage which would reduce the cash flow. I think people tend to prefer CoC for SFH because it says, "Given I have X dollars to invest, how much cash will it generate?".

As a way to compare deals, I prefer Cap Rate, because I consider leverage as an independent decision which exchanges risk for growth. It's also helpful for deciding whether to purchase locally or Out of State, since cap rate vary by region (e.g. Seattle cap rates are much lower on average than Kansas City). But I think for people starting out with limited capital and who want to ensure that they have money in their pocket every month, CoC is a good measure on how much you're left with every month.