Cap Rate Is Not Your Return

[Brady Mullen]

Cap rate is a common and important measurement in real estate investing, but it seems I see it misused more often than not.

Cap rate is an income measurement only. It is a measurement of the annual net operating income (NOI) produced by an asset, relative to that asset's value. Annual NOI/Asset Value. That might sound simple, but it's so often confused with return.

NOI is the revenue minus operating expenses. These expenses include taxes, insurance, HOA, and even maintenance expenses (often missing in cap rate calculations on listings, by the way, so verify!) It is also key to note that debt service (mortgage payment) is not an operating expense, and there's good reason for that.

So, if a duplex receives $60,000/yr in rent, has $10,000 in operating expenses, or $50,000 in NOI (revenue minus operating expenses), and it is worth $1M, then it has a cap rate of 5.0%.

This is true whether you purchased it with cash or with a 75% loan from the bank because debt payments are not an operating expense. They are an acquisition expense.

If you're buying an asset with a 5.0% cap rate, that is not your return. Your return would be the cap rate plus any appreciation.  But not quite...

Your revenue (rents) and your expenses are also likely going to rise over time, so this has to be taken into consideration.

Lastly, this all goes nuts when you introduce a loan/leverage. You didn't exactly buy that property for $1M. You paid $250k, but now, much (or all) of your new investment's NOI must go to cover the mortgage payment.

This is usually when we talk about positive and negative cash flow. We want all the NOI to cover even the debt payment (both principal and interest), which it often does. This is downright remarkable, by the way.

This is harder to do when interest rates are higher, but it can be done by putting more down or investing in higher income markets, or getting creative in other ways.

When people confuse cap rate with return, they say to themselves, "Why would I invest in real estate to get a 5% return when I could invest in something much safer and with much less involvement and get 5%?"

That's a great question! You wouldn't.

However, cap rate is not your return. If you find a property with a 5% cap rate, and you assume 4% appreciation on the asset (averaged over time), and you borrow 75% of the purchase price at an 8% rate (I'm using that to show it can still make sense), your compounding annualized rate of return is closer to 11% over the next 5 years.

And if it appreciates at an average of 5% over the next 5 years, your annualized return jumps to 14% (the loan causes this anomaly where additional appreciation of just 1% will have that effect, which is why it is aptly called leverage).

What's even more outrageous is that your tax-equivalent rate of return is going to be another few percentages higher (depending on your circumstances) because real estate is generally a very tax-friendly investment.

Of course, you won't hear this from most financial advisors.