Buying cash flow properties is one of the greatest ways to build wealth. To do this right, you have to buy smart. Run your numbers, that’s what we say. But how do I exactly do that? This is what we are going to explore. A good way to do this is to determine the Capitalization Rate of the property (Cap Rate in short).

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Capitalization Rate is a crucial indicator for real estate investing because it measures the rate of return on your investment, i.e. how much you get for your money’s worth. However, surprisingly, this concept is often misunderstood within the investment circle. If you ask 10 people what the Cap Rate is for a particular property, nine out of the 10 people will give you a different answer. The last one will ask, “What is cap rate again?”

Jokes aside, the aim of this article is to clearly define what Cap Rate is all about, how and when you will use Cap Rate to analyze your deal, and why different people calculate Cap Rates differently. Learning to calculate and understand Cap Rate is a powerful tool for your real estate investing career.

What is Cap Rate?

In plain English, Cap Rate can be described as such:

If you purchase an investment property ALL IN CASH, for each $100 you put in, how much is your profit per year after you have paid your expenses?

The keywords are: “cash,” “profit per year,” and “after expenses.”

• CASH: It assumes cash, i.e. we don't consider how a mortgage may change our return.
• PROFIT PER YEAR: It assumes there is regular income generated from this property.
• AFTER EXPENSES: It assumes there are expenses being associated with this property.

Often, Cap Rate is represented in percentages. For example, instead of saying Property A’s Cap Rate is $7.50 per $100 invested, we will just say Cap Rate is 7.5%. It means the same thing.

How is Cap Rate Used?

Cap Rate is mostly used to compare income-producing properties. It gives a unified gauge for you to compare, even if the properties are somewhat different.

For example,

Scenario 1

Property A: 2 units, rent = $2000/mo, selling for $250,000
Property B: 3 units, rent = $2500/mo, selling for $300,000

It is quite difficult to determine which one is a better deal. Looking from a purchase price per unit standpoint, Property B seems cheaper ($100,000 vs. $125,000), whereas looking from a rent per purchase price standpoint, Property A looks better (8 per thousand vs. 7.667 per thousand). We don’t know what the associated expenses are for each property, further clouding our judgment.

Related: Cap Rate: How to Best Evaluate & Interpret a Property’s Numbers

Scenario 2

Say the same two properties have the following Cap Rates:

Property A: Cap Rate = 7%
Property B: Cap Rate = 7.5%

It is clear that Property B is better because having a 7.5% return is better than a 7% return. We also know that all major items such as incomes and expenses are incorporated into the analysis.

Limitations of Cap Rates

Before we start saying, “Oh, great” and go hunting for all properties with the highest Cap Rates, here is a small caution. We cannot simply look at this number to evaluate a deal. There are two reasons for that.

It’s Not Just About the Rent

First, Cap Rate assumes there is regular income (rent) being generated from the property. However, not all real estate is income-producing, and it can be good investment as well.

A good example is raw land. While raw lands do not generate at the moment, some investors purchase such lands and wait for the market to go up before selling or developing them.

Another example will be homes that are predominantly used for personal uses rather than rentals. They tend to be single-family homes in high price points neighborhood such as Beverly Hills in Los Angeles, Coral Gables in Miami, and Manhattan Upper East Side in New York. Think of the houses that you see on TV show “Million Dollar Listing.” The values of these properties are not mainly driven by the rents they could command, but rather by how emotionally attached a prospective owner is to buying the house.

Price Appreciation

Secondly, Cap Rate does not capture an important factor: future price appreciation of a property. Cap Rate focuses on present income and expenses, but does not consider any future growth or decline of the neighborhood. Which deal do you think is a better deal: a house with a Cap Rate of 8% but in a town where people are leaving due to job loss and crime, or another house with a Cap Rate of 6% but where the city is thriving and house price increases by 10% each year? The first house may sound better, but if you consider house appreciation as well, the second one is definitely a better option.

When Should Cap Rate Be Used?

In general, Cap Rate is most useful in areas where the majority of houses are occupied by renters rather than homeowners. Most houses in such areas tend to be multi-family housing (e.g. 2-family, 3-family, 4-family, etc.).

How Do I Calculate Cap Rate?

This section is very detailed. Feel free to skip this section for now and get back to this once you understand the big picture.

Here is an example. This is based on one of the properties that I own. I rounded up some numbers to make the calculation easier.

Let’s revisit what Cap Rate means.

If you purchase an investment property ALL IN CASH, for each $100 you put in, how much is your profit per year after you have paid your expenses?

(Note: Profit is simply Income minus Expenses.)

Here are the numbers:

Income: $3,200 per month. It is a 2-family home. One tenant pays around $1,200 per month and the other $2,000. So the total income is $(1,200 + 2,000) = $3,200 per month.

Expenses: $1,950 per month. For expenses, the expenses that I account for are $1,950 per month in total. They consist of rent loss due to Vacancy, Property Management Fee, Maintenance Fee, Property Tax, Utilities Fee, Insurance etc. Note that mortgage is NOT part of the expenses. (Remember, the calculation assumes the property is purchased ALL IN CASH.)

Profit: $15,000 per year. Since each month I collect $3,200 per month and pay $1,950 per month, there is $(3,200 – 1,950) = $1,250 per month in profit. This is equal to $(1,250 x 12) = $15,000 per year.

Cap Rate: 7.5%. I paid $200,000 for this property and receive $15,000 in profits each year. For each $100 that I invest in this property, I receive $7.50 in return each year. Therefore, Cap Rate is 7.50% ($7.50 = $100 x 15,000 / 200,000).

Next, let’s look at how I come up with these numbers.

For Income, it’s pretty simple. These are my actual rent figures.

If you don’t know the actual rent, the best way to get the numbers is either by talking to rental agents for their estimates or going online (Craiglist and Zillow are often good sources) to see how much similar places are being rented out for. Based on my experience, I find that it is the bedroom count, not the finishing of the apartment, which mainly determines the rent. This is especially true for government-subsidized (Section 8) housing. (That being said, better quality housing attracts better tenants, which is equally if not more important, but we stray away from the topic…)

Expenses, things like Property Taxes, Utilities, and Insurance, can easily be verified from the city office or service providers. Call your insurance broker, electric/water companies, and your city office. A lot of people think the expense numbers are very hard to find, but they are easier than you think. They are nearly always fewer than two calls away from getting the information that you need. Most of them are online anyway. Once you have found out a few, you will also become familiar with the prices in your area and will be able to do a ballpark estimate quickly. For example, for water in my town, it is roughly $50 per month per unit (so $100 per month for a 2-family house).

Vacancy, Maintenance, and Property Management Fee are more open to discussion. The key difference between these factors versus the others (Tax, Utilities, Insurance) is that costs like vacancy, maintenance and property management fee may not be as absolute.

In my example,

• I do not pay $240 per month for “vacancy”–it is a fully occupied property.
  
• Nor do I regularly pay $240 a month to maintain the property–it is sometimes more, sometimes less.
  
• Nor do I pay a property management fee–I do it myself.

If these are not regular expenses, then why am I considering them? That’s because while these expenses won’t happen each month, eventually these expenses will become real, and you do have to pay for them. At some point my tenant is going to move out, my toilet is going to clog, and I will be too busy to manage all the properties. They all cost money.

By counting these so-called expenses now, I will be much more prepared whenever any surprise comes up. Instead of getting shocked each time by any major fixes that I need to pay, I have a budget that accounts for it. As usual, a bit of preparation and planning goes a long way.

A related question is: How do I come up with these estimates? There is no absolute certainty in these. These are the best estimates for such costs. For example, I expect I lose roughly one month’s rent whenever there is a tenant move-out. Since I assume a tenant usually stays for a year, that’s roughly $3,200 per year. Divide this number by 12, and that’s roughly $200 to $300 per month, so I pick $240. I estimate the maintenance cost to be roughly the same. For property management fee, I know if I have to hire a property manager to do the job, around 7-10% of the rent will be allocated.

In the example above, I use 7.5% of monthly rent for both vacancy reserves and maintenance, and 10% for property management fee. Unless the neighborhood that you are looking at is either extremely good or bad, these estimates should be similar to your area as well.

Why Are There Different Cap Rates for the Same House?

Often when you ask a real estate agent for the Cap Rate, you get one number. When you ask a real estate investor, it will be a different number. Why would this be possible on the same property?

The answer is pretty simple. Both seller and buyer have his/her own biases. A seller always want to bump the rate of return as attractive (high) as possible, and the buyer will do the opposite, pushing the rate as low as possible.

Related: A Definitive Guide to Understanding Cap Rates and Cash-on-Cash Returns

How would each achieve it? Remember we said numbers like maintenance and vacancy loss are merely estimates? Because of that, there is a huge room for interpretation/manipulation.

Let’s use the same house and see how a seller or a buyer can change the values.

By altering certain assumptions, one house can have a Cap Rate that ranges from 6% to over 12%, even with the same purchase price! I won’t comment who is right and who is wrong. It depends on what picture you are trying to paint. What is important to remember is:

1. The numbers are subject to manipulation (and people do that).
2. Choose numbers that work for you. If you pay 10% on average for property management fee, and the rent is $3000, put in $300 (10% of $3,000) as management fee expenses. Don’t put in $200 to force the deal work. Use the most real numbers that you can get.
3. For buyers, don’t forget to shop around for cheaper and/or better vendors to increase your Cap Rate.

Final Thoughts

If you want to invest in cash flow properties, you have to learn how to use Cap Rate correctly. This article gives you a good reference of everything you need to know about Cap Rate. Good luck finding and analyzing your next deal!

Investors: Have any questions regarding Cap Rate? Want to add to the discussion?

Be sure to leave your comments below!