Newbie question about Rentals, Caprate and etc

[Jean-Claude Governale]

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.

[Chris Washington]

@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!