What is a Cap Rate and why is it so important?

Question

HI BP Community!

Can you help demistify Cap Rates? What is a Cap Rate? What does it tell me about the property? Why is it so important? I've read how to calculate Cap Rates, but I just don't get it...yet.

Thanks in advance!

Alyssa

Roy N. · Answer

@Alyssa Baron

A lot of people "don't get it", yet Capitalization Rate (CAP) is one of the most bandied about and misused ratios in real estate.

On the surface it is simply the ratio of the Net Operating Income (NOI) to the acquisition cost of the property (NOI / acquisition cost).

It's purpose is to allow you to compare the relative cost of similar cash-flows (since you a really buying a business, not a property) in an area.  The catch is that to make a meaningful comparison the CAP rate for all cash-flows (properties) being compared need be calculated using the same methodology.   Consequently, NOI needs to be calculated the same in each instance, as does the full acquisition cost of the property (purchase price, closing costs, any immediate rehab costs required to be rent ready, etc).

When you see CAP rates listed in pro-forma or memoranda of offering, they are typically "rosy" - the scheduled rent is used in lieu of the gross revenue (no vacancy allowance made) and the operating expenses fail to include maintenance or property management allowances.

Another common misuse of CAP is to compare similar properties (cash-flows) in different areas/market.   Assuming the calculations were performed the same, a property in Manhattan with a CAP of 5 might be quite attractive, while a similar property in Cleveland would be considered over priced at that CAP rate.

As a final note, CAP rates are used most commonly when dealing with commercial real estate.  While you can calculate a CAP for residential real estate (1-4 units), these properties are typically priced using sales comparisons and not based upon their cash-flow, making the calculated CAP rates less reliable.

Hal Thompson · Answer

@Bob Bowling

Why is it ridiculous to compare a cap rate to a rate of return from another investment (or to keeping the money in an interest bearing bank account?). You should read this: http://www.propertymetrics.com/blog/2013/06/03/cap...

NOI/Purchase price = unlevered rate of return. In other words, this metric allows you to approximate the rate of return you can expect on your money versus another investment.

It is true that you cannot compare cap rates between different property markets. This is because the amount of risk you are willing to take must scale with the market you enter. A 4 cap in Detroit would be entirely unacceptable, because the risk you're taking by entering that market is huge. On the other hand, property in downtown Manhattan is almost guaranteed to appreciate, so you might be willing to accept a lower rate of return (ie 4 cap or less) in the short term in anticipation of making higher returns on appreciation.

Seth Weatherly · Answer

@Alyssa Baron

I agree with bits and pieces of what's been said above, but in more simple terms, it's a way to estimate value based only upon NOI (in addition to cap rates derived from comparable deals, which are relatively easy to obtain). They are similar in nature to a gross rent multiplier in multi-family deals, which is a more straight forward metric, in my opinion.

(Note: I think there is a return relationship between cap rates and returns, however I think it's much more convoluted than using the IRR (internal rate of return), which is more closely related to the method of calculating returns for other investments (CDs, Bonds, stocks, etc).)

From an appraiser's point of view, cap rates are important because they are a major component of income capitalization approach (discounted cash flow) to value, which is one of three approaches used by professional appraisers to value commercial real estate. And unlike the sales comp or cost approach, it is the only method that uses income to derive a value, which is what investors and lenders are most concerned about anyway. In theory, all three approaches should yield very similar values, which lends legitimacy to the value estimate. (In actuality, there are many reason why they may not reconcile. So when you, as an investor, are valuing your personal income producing property or a potential income producing property deal, gathering accurate cap rate data is essential in getting the value correct (using an income approach, that is).

As a side note, professional commercial real estate investors (REITs and PE funds) and commercial lenders rely almost exclusively on DCF values, so if you're looking to get into that space, they will expect the same.

So, just to wrap up, let's say you've worked like crazy to get your pro forma income and expenses modeled correctly for a property you'd like to sell and you're confident that your NOI estimation is as close as it can be. From that point, you can gather cap rate data from comps, brokers or market publications and use that to derive a value simply by dividing your NOI by your market derived cap rate. (i.e if your NOI is $500,000 and your market derived cap rate is 8.0%, you should not sell the property for less than $6,250,000)

Apologies for such a long-winded answer, would be happy to clarify directly if it would be helpful! Good luck!

Hal Thompson · Answer

"So if you have a 12% cap in Detroit and a 4% cap in SF how do you compare it to the going CD rate?   You can't.

Why not? If the going CD rate is 4%, and the cap rate in SF is 4%, you could argue that absent appreciation, the SF deal is a bad deal. Instead of investing in real estate, I'll keep my money in the CD, do nothing, and make the same return. All the headaches involved in real estate investing you point out just tip the scales further towards the CD.

Plus, the focus on the CD is not the point. The point is to evaluate versus the other opportunities you have for your money. If the cap rate is too close to the return you can get from a safer/easier investment, this suggests you shouldn't invest.

All investing boils down to trading risk for return. if the risk seems out of whack with the return, because there are investments that make the same return with less risk, this suggests you shouldn't invest.

Steve Olafson · Answer

Yep.... Some of my most profitable deals were zero cap rates at time of purchase.  Cap rates are not only location driven but condition driven as well.

Andy Luick · Answer

You will get a bunch of different explanations but, to me, in simplest terms, it should be the expected rate of return on a project.  For some it's as low as 3% or 4% for others it is 10% or more.  To me it's what rate of return on a deal will get me to move my money from my pocket or bank into the project.  We use it to "snapshot" value a deal by dividing gross or net cashflows by the cap rate to get a value.  Using a lower cap rate or applying it to gross rents gives you a higher value.  We always use 10%..or almost always......and apply it to net rents for a more accurate value.  Everyone is different and our model is pretty unusual anyway.

If you are a new investor, you may want to check into groundfloor.us where you can earn an 8% to 12% return secured by the property.  They perform all of the front-end due diligence and you can invest as little as $100.  Not a bad way to go.  I'm a turn-key investor and even I'm putting funds into it.  It gives you the opportunity to participate in deals, learn from them and even visit & shadow if you are in the same market.  Really a great way to get started.

Roy N. · Answer

Ihe:

I do not believe we were making things complicated above.   Mathematically, the CAPitalization Rate is a simple ratio (as depicted in several posts above).  The problem arises in how it is often {mis}applied.

Looking at your particular example of a SFR, I would suggest the use of CAP rate immaterial, though perhaps interesting, simple because houses are bought and sold using comparable sales and not based upon the cash flow they produce.

Setting your minimum acceptable rent at $1K/month is fine, provided your operating expenses, reserves, and debt service are less than that amount (i.e. no more than 80-85%).  Such a measure will help to keep you looking in one type/class of neighbourhood (e.g. 'B)'.

Account Closed · Answer

Either they are all making it too complicated or I am making it too simple.

I don't know what a cap rate is.

I target $35k as the cost of acquisition including upgrades to get a house to be rentable and I expect circa $1k a month in rent for that. I arrived at  those benchmarks because they were more or less handed to me on the first 2 deals that I did (actually both deals came inside those figures).  I did not do any a priori analysis for those deals but my gut told me based on the price of the houses and the projected rent that the deals were  no-brainers.

My other rule of thumb is to only buy houses that I think will rent for close to a minimum of $1k a month.

Michael Win · Answer

I understand cap rates and understand that it is a good tool to compare properties.  But I think Cap rate is very misleading.

I just bought a property for 1 mil, owner last year brought in 80K so his cap rate is 8%.  Pretty good but IMO, nothing great.

I purchased it with financing at 20%, rate 4% and have NOI of 35K.  SO, I am getting 35k/yr on a 200k investment which is a 17.5% which is GREAT.   If I can push the rent up 200/door in 5 yrs, I would pull in 60K/yr and a return of 30% which is amazing.   This is on top of the appreciation which the duplex sales price has doubled in 5 yrs.

From my point of view, Cap rate is good to compare two properties.  Investment return % gives me a better idea if the investment is worth it.

What is a Cap Rate and why is it so important?

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