My last post discussed how to analyze the financials of an income-producing property. In that post, I discussed a bit about Cap Rate and how to calculate it. But, I didn’t spend a lot of time discussing why it’s such an important metric. In this post, I’ll try to do that…
Let’s say you were buying a property (in this case, assume it’s any type of income-producing property other than a single family home), and you wanted to know if the property were a good investment. What information would you ask the seller to determine if the property were one that you should buy? For many investors, the first question that comes to mind is, “What is the cash flow of the property?”
Note: For those not familiar with the term “cash flow,” it is the amount of money the investor will have left over after collecting the monthly income from the property and paying all the expenses (including property taxes, insurance, maintenance, mortgage, etc). So, a property with a $5000 per month cash flow will allow the property owner to pocket $60,000 per year.
While this seems like a reasonable question from the perspective of a potential buyer, there is one major problem with asking what the cash flow is on a property: the cash flow is going to be different for each potential buyer. This is because the cash flow is directly affected by the expenses associated with the property; the higher the expenses, the lower the cash flow. And while a number of the expenses associated with a property are will not vary depending on the owner (for example, property taxes, insurance, maintenance, etc will likely be the same regardless of who owns the property), one key expense item will be very much dependent on the specific buyer – and that’s the debt service payments (mortgage payments).
The debt service payments are going to be directly related to the interest rate on the loan, the amortization period, and the down payment amount. Because two buyers will likely use different financing mechanisms, one is likely to have higher debt service payments than the other. And because cash flow decreases as expenses increase, the one who has higher debt service payments will have lower cash flow as well. In fact, on the same property, one buyer who gets a loan with a low interest rate and a big down payment could have positive cash flow (i.e., he’ll make money each month on the property), while another buyers who gets a loan with a high interest rate and small down payment could have negative cash flow (i.e., he’ll lose money each month on the property).
Because my cash flow will likely be different than your cash flow on the same property, it doesn’t make sense to determine the value of the investment value of the property using this metric. This goes for several other popular metrics used to determine the investment value of the property as well – cash-on-cash return, total return, etc. That’s because these investment metrics are also specific to the buyer’s specific circumstances (debt service payment, tax bracket, etc).
So, if none of these metrics is a good measure of the value of the investment independent of the specific buyer, what is?
That’s where the Cap Rate comes in…
The Cap Rate is a measure of a property’s investment potential, independent of the specific buyer. Regardless of who is evaluating the property, the Cap Rate will remain the same, and therefore two investors can do an apples-to-apples comparison of the same property using this measure.
That is why cap rate is such a valuable tool.
Related posts:
- Worshiping At the Altar of Cap Rates? You Could Be the Next Sacrifice
- Interest Rates Climb to 8-Month High
- Determining the Value of an Apartment Building Investment Using Cap Rates
- How to Be a Successful Real Estate Investor. The Story of One Valuable Pre-Foreclosure Lead.
- Real Estate Investors: Time Is Our Most Valuable Asset – Use the Lock Box!
Article Author: 
Joshua Dorkin
{ 5 comments… read them below or add one }
Thanks for the info Scott!
I have a question regarding the Cap Rate. It seems like this is a global metric that is useful in defining an asset’s capitalization rate. But, say a cap rate is given at 20%, then it would appear that one is making that much in ‘profit’ each year. BUT, what if the money that is going into servicing the debt on the house, and/or the total cost of the house, was put elsewhere, for example in bonds, funds, stocks, etc. You see, I’m not so sure that it’s such a good way to measure the efficacy of an investment. What do you think?
You da’ man J Scott. Good summary. Now if we could only get real estate agents, Sellers and marketers to provide ACTUAL numbers and cap rates we could save everyone some time!
Dirty Word in My World: “Proforma Cap-Rate”
Great article ! The prior comment by Steve was head on in that very few listings will indicate what the cap rate is. Is such a valuable metric to evaluate an investment opportunity.
Good info, and cap rates are very useful. But they can still be subjective:
Because the cap rate depends on the net operating income (NOI), the seller can “cook the books” and assume a higher NOI, whereas the buyer may want to include a few more real expenses and has a lower NOI, thus a lower cap rate.
But using all apples, it’s a good comparison tool, or the other way around even a good tool to determine a purchase price with a desired cap rate on the buyers side.
I think that all these evaluation methods are good to help establish a value, yet No one it self means much as the cost per unit/square foot and the gross income that unit produces.That’s the MOST accurate and real information one can use to proceed with an actual evaluation.