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Cap Rate Made Simple

Posted on Tuesday, July 08, 2014

We hear the term cap rate used a lot but what does it really mean?  How is it used?

Cap rate is defined as: “the rate at which you discount future income to determine its present value”.  If you have not already, I recommend everyone immediately go buy the following book: “What Every Real Estate Investor Needs To Know About Cash Flow” by Frank Gallinelli.  Another definition that can be found online is: the ratio between the net operating income produced by an asset and its purchase price.

How do you calculate CAP rate?

Capitalization Rate = Net Operating Income/Value

It’s true that this measurement is used primarily for commercial properties where the value is determined by its income.  However, if you’re getting into the real estate investing game you should be familiar with this method of valuation.  This is a market driven measurement so you must do additional research to determine what the average cap rate is for the particular area in which you wish to buy.  It is also one of many measurements that are used when evaluating a property and not should be used as the sole method of making your decision.

How is it used?

This isn’t really necessary for evaluating single family homes because of the sales comparison method of valuation.  However it is very relevant to multifamily residential properties.  If your research indicates that a particular type of property in your area will sell for a particular cap rate you can determine a fair purchase price if you have the details on the income & expenses:

Net operating income/Cap Rate= Value

There are investors who will use this measurement when looking at single-family houses so you should be familiar with it if you plan on working with investors.

I recently did a transaction with a portfolio of 7 single family houses in a rural area of North Carolina.The numbers for the houses looked like this

3150 (Gross Monthly Income)

1260 (Vacancies, Repairs, Taxes, Insurance)

1890 NOI (Net Operating Income)

22,680 Annually

The seller’s asking price was $120,000 for all 7 properties.So the question becomes is this a good deal?Well, the CAP Rate would be 19% 

22680 (NOI)/120,000(Purchase price) = .19%

Since this was a cash deal and no mortgage would be used this meant that the ROI (Return on Investment) was the same.  Cap rate and ROI will not be the same when financing is used.

So does a CAP Rate of 19% make this a good deal?  Well, the buyer is getting 19% on their money.  Few assets will show that kind of return.  If all goes to plan the buyer will have his money back in a little over 5 years.  What other investment opportunities are available at 19% ROI? The thing to remember is that this measure is market driven and these properties were in a rural area that lacked an active market so there wasn’t anything to compare them to.

After a few weeks I was able to find a buyer for this property.  He had recently come into a nice chunk of cash that he needed to invest for some cash flow.  He had a couple of rental properties but he was somewhat new to real estate investing.  While speaking with him he never mentioned anything about the cap rate.  The only number he was concerned with was how much money he would be making per month.  The important thing was that I had the numbers prepared ahead of time to be able to sell the advantages of this type of investment and respond to any objections.


Comments (10)

  1. No_avatar_tiny

    It sounded like the deal made since, very good Michael.

    By the way I want to start buying in No Carolina, can you help me put together a power team so I can start buying properties down there, thanks so much!


  2. Tiny_1399737920-avatar-honobob

    You got it completely WRONG!  You get your cap rate comp and multiply that by your desired property's NOI to get market value of the property you want to buy.


    1. Tiny_1399315547-avatar-clemsoninvestor

      "WRONG!" seems a little strong here, don't you think? Cap rate  has many different nuanced definitions and there are certainly many more ways to use it without it being wrong. 

      Yes, many people use a market comp to get the target property's market value.  But it's perfectly reasonable to use it the way @Michael Otranto did as well.

      I buy lots of single family and multifamily properties, and my primary calculation on every one is to figure out the most I'll pay by dividing the NOI by my target cap rate for that type of property in that location.  

      Works well for me (and many others). 


  3. Tiny_1399737920-avatar-honobob
    Oops, ÷ by.

  4. Tiny_1404905591-avatar-michael_otranto

    lol, that's what it says.  

    Net operating income/Cap Rate= Value 


    1. Tiny_1399463644-avatar-smreilly

      Yes but I think Bob's point is that rearranging the formula to:  

      Cap Rate = NOI/Purchase Price is not the same thing, and is a fairly meaningless calculation as Cap Rate is a constant (That admittedly can and will shift over time) for the market and is used in that first formula to determine value.


      1. Tiny_1404905591-avatar-michael_otranto

        @Shaun Reilly  "Cap Rate = NOI/Purchase Price" is not the same thing as what?  The point of the article is that it's one measurement among many that investors need to be aware of when buying, and especially selling, real estate.  My buyer never asked me about the cap rate in the example above but I needed to have it prepared for any potential buyer.  


  5. Tiny_1399698864-avatar-fritzbucyrus

    Good blog @Michael Otranto 


    1. Tiny_1404905591-avatar-michael_otranto

      Thanks @James Wise 


  6. Tiny_1406142752-avatar-04mojami

    I've read on some blogs that you don't necessarily want a very high cap rate either as this would indicate the type of property being purchased is a "C" property in most cases and so there's a magical cap rate that one should aim for... Does anyone have an idea of what that should be? As for me, I'm thinking I'd love to invest my money in a return of 19%... seems almost too good to be true.

    Thanks,

    Jamie


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