Newbie question about Rentals, Caprate and etc

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Newbie question about Rentals, Caprate and etc

Jean-Claude Governale
Gibsonton, FL · Member since 2016 · 14 posts · 0 votes

Good Morning BP community, first let me say that I have been following the forums, pod casts, blogs and everything on here for about a month now, and I love this community, so much amazing information.

I am a new investor in Florida, and I have been looking at rentals.I've read about cap rate and I believe I understand the formula for calculating it, but I still have some questions about how valuable it really is and if cash flow is more important?

I was wondering why cap rate is calculated on the value of the property, not actual income invested into the property?I would think that the rate of return on capital invested is more important than the rate of return on the value of the investment.Now I understand if you do not finance the property, pay off and have no mortgage, then yes, I can see how that can be very useful.But from what I have heard and read, it seems a lot of people do finance their investment properties so how big of a role should cap rate be when financing a property for long term rental?

I've read people talking about 10,12,15% cap rates on rental properties.But wouldn't cash flow be more important. Say for example you have property that is generating btwn 400-500 cash flow but the cap rate is 2%, wouldn't that still be a good investment property for a buy and hold?

Thank you for taking a moment to read this.

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Chris Washington
Cincinnati, OH · Member since 2016 · 62 posts · 52 votes
10y

@Jean-Claude Governale

The best definition I've heard of CAP rate is a measurement of the risk premium of your investment when compared to 10-year Treasury Bill (considered a "risk-free" investment). For example, if the T-bill is paying a 2% return, and you can purchase a property with a 7% CAP rate, you are receiving a 5% premium on your investment in exchange for your time and accepting the inherent risk associated with investing in Real Estate.

In essence, unless you are betting heavy on future market appreciation or have a strategy to quickly force appreciation in the asset, there is really no reason to purchase a property at less than the current yield for the T-bill as you would be better off investing in the risk-free T-bill. The definition of a "good" CAP rate varies by market and must be determined by each individual investor in terms of their overall investment strategy.

CAP rate should not be the only measure of the quality of an asset. I would also recommend looking at other metrics (i.e. Cash flow, Cash-On-Cash return, Debt Service Coverage Ratio, etc.) to determine your whether an investment is right for you.

Hope this helps...best of luck!

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  • Jaysen Medhurst
    Rental Property Investor · Greenwich, CT · Member since 2015 · 4k+ posts · 2k+ votes
    10y

    Hi @Jean-Claude Governale, this is a good question.

    Cap Rates don't take financing into consideration for a few reasons:

    1) Financing varies widely by property. Since property A may be financed w/ 40% down at 5% over 20 years and property B is financed w/ 30% down at 4.5% over 30 years, you can't compare them using Cash Flow alone. Cap Rate give value regardless of the terms of the financing

    2) Financing varies over time. Rates and terms change over time (the last 7-8 years not withstanding). So again, Cap Rate allows you to evaluate properties and markets over time. 

    As to what's more important, Cap Rate or ROI, that's a question each investor has to answer for themselves.

    Finally, your example of the $400-500 cashflow property that has a Cap Rate of 2%. A lot depends on the situation. For example a duplex that CFs that much might be a good investment. A 24-unit apartment community...not really. 2% Cap Rate in a super competitive/hot market might be acceptable (though not to me) if you're investing for appreciation or have other plans for the property (e.g. taking apartments condo).

    To better understand investing metrics and their limitations, I highly recommend the @Frank Gallinelli book .

    1Reply
  • Jean-Claude Governale
    OP
    Gibsonton, FL · Member since 2016 · 14 posts · 0 votes
    10y

    Jaysen, thank you very much for the reply, that does help.

    As a newer investor, I was looking at a triplex in my area, in initial number crunching, it appears it would cash flow nicely and in a good neighborhood.  But as mentioned the CapRate is low.

    Obviously being a brand new investor, I want to invest wisely, and avoid any new investor mistakes.

    Thank you, other replies are also very welcomed and appreciated.

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  • Chris Washington
    Cincinnati, OH · Member since 2016 · 62 posts · 52 votes
    10y

    @Jean-Claude Governale

    The best definition I've heard of CAP rate is a measurement of the risk premium of your investment when compared to 10-year Treasury Bill (considered a "risk-free" investment). For example, if the T-bill is paying a 2% return, and you can purchase a property with a 7% CAP rate, you are receiving a 5% premium on your investment in exchange for your time and accepting the inherent risk associated with investing in Real Estate.

    In essence, unless you are betting heavy on future market appreciation or have a strategy to quickly force appreciation in the asset, there is really no reason to purchase a property at less than the current yield for the T-bill as you would be better off investing in the risk-free T-bill. The definition of a "good" CAP rate varies by market and must be determined by each individual investor in terms of their overall investment strategy.

    CAP rate should not be the only measure of the quality of an asset. I would also recommend looking at other metrics (i.e. Cash flow, Cash-On-Cash return, Debt Service Coverage Ratio, etc.) to determine your whether an investment is right for you.

    Hope this helps...best of luck!

    2Reply
  • Jean-Claude Governale
    OP
    Gibsonton, FL · Member since 2016 · 14 posts · 0 votes
    10y

    Chris, that does help, thank you.  So with what you said in mind, how does a new investor find what the avg caprate for my market is??  I am also sure that is ever changing, i.e. as properties increase in value, sometimes faster in hotter markets, but how do you find that number?  I'm sure if I spoke to 50 different investors in my local market, I would get a dozen different Avg Cap Rates..  All depending on when they bought, the deal they made, or how low they bought....

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  • Chris Washington
    Cincinnati, OH · Member since 2016 · 62 posts · 52 votes
    10y

    @Jean-Claude Governale

    Couple recommendations:

    1. Visit loopnet.com and look up the type of property that you are interested in, in the area that you are interested in. Many of these properties have advertised CAP rates. While the proforma information is typically inflated, the advertised CAP rates should give you a decent indication of the CAP rate range for the type and class of asset.

    2. Connect with a local commercial broker in your area. You may not want to do this until you are serious about investing (i.e. if you found the right investment that met your criteria, you would actually buy) so as to not be labelled a tire kicker. But a good broker should be able to give you a range of CAP rates by asset type in your area

    3. You can always post here on BP and ask other active investors in your area what CAP rates they are seeing. If you take that option, just be sure you specify exactly what type of property, class of asset, and class of area otherwise you won't get much help.

    Finally, 2 BP forum best practices:

    1. When responding to posts on BP it's best to "mention" the person by using the @ and their name (i.e. @Chris Washington). Fortunately I came back to check this thread, otherwise I would have never known you wrote a response to my initial post.

    2. If you find someone's post helpful, be sure to vote for it. This lets the poster know they are providing value, and allows the community to recognize people who provide quality contributions to the forums.

    Hope this helps! 

    1Reply
  • Jaysen Medhurst
    Rental Property Investor · Greenwich, CT · Member since 2015 · 4k+ posts · 2k+ votes
    10y

    @Jean-Claude Governale, one final point to keep in mind: "Residential" properties (i.e. 1-4 families) are not appraised based on Cap Rate. They are appraised based on market value--what other similar properties are selling for. How much money that property is making won't matter to the appraiser. He's looking at comps.

    5+ unit properties are considered "commercial" meaning their value is NOI*Cap Rate. Obviously, that leaves a lot of room for interpretation/negotiation, but the distinction is important.

    If you squeeze an extra $1000 a year out of a 4plex, it will still appraise based on similar properties. If you do the same to a 5plex and the local Cap Rate is 10%, you've just added $10,000 of value to the property. This is called "forced appreciation" and can be a very powerful tool.

    @Chris Washington, I really like the relation to T-Bills that you pointed out. I haven't heard that before. Thanks for sharing.

    2Reply
  • Mallikarjun Reddy Pateel
    Investor · NJ · Member since 2021 · 121 posts · 33 votes
    5y

    Cap Rate is Only Considered for 5+ Units, for 1-4 we do Comparables(Similar Properties in Neighborhood same Size, Features). Cap rate is Calculated to get the Market Value of the Property. Cash on Cash Return Calculated to Get the Initial Return on your Cash Investment

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