BiggerPockets

CAP RATE means Capitalization Rate, it is a term that is generally used for commercial properties.

At its most simplest form the Cap Rate is

Revenue/purchase price

For more detailed information:
http://en.wikipedia.org/wiki/Cap_rate

Cap Rate, Short for capitalization rate, is the rate of return you would get for an income producing property if you paid all cash.

It is calculated by dividing the price of the property by the Net Opperating income, (rents-expenses). Do not include interest or principal payments in the expenses, This is figured separately.

Your actual return on the property is generally higher because of the effect of financing. You need to figure your actual return separately.

So why do they figure " Cap Rate" without financing? It is an esay way to compare properties. Since everyone would get different financing brokers can't adverties a specific return on investment but they can advertise Cap rate so buyers can compare properties.

By the way 15% would be an outstanding Cap Rate for a commercial property - IF it is calculated correctly.

My partners and I am actively lookng for commercial properties . Teh returns can be phenominal for the right property.

I'm not sure what you mean by " cash flow" in your examples, so lets back up.

Gross scheduled rent = total rent that you would get if the property was rented for the entire year at the full expected value.
Vacancy = rent you don't get, either because its vacant (actual vacancy) or you've given a discount (e.g., first month free, economic vacancy.)
Expenses = All costs related to running the property. Insurance, taxes, utilities, maintenance, HOA, legal fees, eviction costs, tenant damage repairs, make ready, etc., etc., etc.
NOI = net operating income = Gross scheduled rent - vacancy - expenses.
Cap rate = NOI (for a year) / Purchase price
Debt service = mortgage payments. May be interest only or amortized.
Cash flow = NOI - debt service
Taxable income = NOI - depreciation - Interest payments

The measure that affects you on a daily basis is cash flow. Tax, which is calculated on the taxable income (which can be negative due to the depreciation) may be a factor, too.

ROI is interesting, but if you invest $10 and earn $10 you have 100% ROI, but still only $10 in your pocket.

Cap rate is generally used for commercial properties, not single family properties.

Don't forget closing costs. Real estate is one of the worst investments in terms of the transaction costs. Neglecting them will significantly affect you results.

There's a book titled " What every real estate investor needs to know about cash flow" . I really recommend getting a copy. Not exactly something you read from cover to cover, though I would actually recommend trying to do that. It covers these formulas and many others.

Yes it is. Frank posts here once in a while.

Another great book that will help in this area is Steve Berges' The Complete to Real Estate Finance for Investment Properties. He explains the various terms, ratios, and calculations very well.

Who or what are you referring to? I didn't see any incorrect answers. I did see some abbreviated answers, including mine, that perhaps didn't clarify things or define things well enough. Cap Rate, it's purpose, and how it is used is very difficult concept to get across, especially in a short forum post.

Unless you are planning to buy large commercial properties, I would forget cap rate and all the other mumbo-jumbo. It is totally irrelevant for SFHs and small commercial properties.

I agree, cap rate itself doesn't have much value for SFHs. However I believe understanding the numbers, knowing how to use an APOD, and knowing the numbers needed to calculate it are important for any income producing property. Cap rate is only one part of cash flow analysis that you should be doing on any income property.

The entire purpose of cap rate, as far as I'm concerned, is to allow you to compare one income producing property with another when screening deals.

With that said, I've got to agree with Mike here: for small properties, cap rate is useless.

I'm going to go one further and say that for large properties, it's useless too.

Why?

Because brokers and sellers LIE all the damn time. Cap rate is worthless as a screening tool because you can't trust a cap rate until you verify it with at least some pre-offer due diligence, like a couple of years of monthly P&Ls. And of course, by that time, you are able to understand the expenses to some degree and calculate some much more useful ratios, you know, like Cash-On-Cash return, DSCR, etc.

I'm going to go one further and say that for large properties, it's useless too.

Why?

Because brokers and sellers LIE all the damn time. Cap rate is worthless as a screening tool because you can't trust a cap rate until you verify it with at least some pre-offer due diligence, like a couple of years of monthly P&Ls.

I think the point here has been missed. Cap rate is ONE great screening tool. It is the proper calculation of the expenses to arrive at a true NOI that is often done incorrectly. Just because a seller or seller's agent lists a property's cap rate under false pretense does not make evaluating cap rates worthless, it means that we as investors MUST evaluate the P&L (as you stated) properly to arrive at the real NOI and not the stated one.

As far as cap rates for SFR and up to 4 unit multifamily, Mike was exactly correct. These types of properties rarely have sufficient and accurate P&L's to arrive at a true cap rate, plus, residential properties values are based on comps, in comparison to commercial properties which values are based on the income they produce. This does not mean that you should not use an income approach as an investor on res. properties, just pointing out how RE is valued in each class.

Revenue/purchase price

Wrong. Cap rate = NOI divided by purchase price.

Although it is a matter of semantics, I wouldn't say Ashamann's answer was wrong. NOI is a form of revenue. He did say in it's simplest form and gave a more detailed link.

I have to take a bit of exception to that. Its not a matter of semantics. " Revenue" and " NOI" need to be precisely defined terms for any of the math to make sense. NOI is precisely defined, as is purchase price. So saying " cap rate = NOI / Purchase price" has an exact meaning. The term " revenue" is rarely used for REI. In business accounting, it means the money coming in the door, though the more precise " gross revenue" would be a better term. After subtracting off COGS (cost of goods sold, i.e, what you paid for the stuff you sold), you get " gross profit" . Subtract off SG&A expenses (selling, general, and administrative), you get " net profit" . " Net profit" is equivalent to what we call " NOI" . So, I think its incorrect, and not just semantics, to say " cap rate = revenue / purchase price."

If you equate revenue to the gross scheduled rent, then revenue (monthly) / purchase price is the " 1%" or " 2%" rent factor. Or, its the inverse of the Gross Rent Multiplier GRM = purchase price / annual gross scheduled rent.