An Investor Answers: Why Does the Cap Rate Formula Not Include Debt Service?
There was a period of time when writing became cumbersome. I felt I’d written so much that there was nothing more I could add.
Want more articles like this?
Create an account today to get BiggerPocket's best blog articles delivered to your inboxSign up for free
And then I was reminded that writing, as much as I happen to enjoy it, is nonetheless not about me — it’s about you, and as long as you have questions, I will never run out of things to write about. And guess what? The questions just never stop. So, here we go.
The Question That Came in Yesterday
I am really busy nowadays since I am preparing my house and some of the apartments for the market as part of relocating my family to Arizona, where the weather is so much better than in Ohio, and my buddy Serge S. and I will be so bored on the golf courses together. Being busy means I don’t open the email as often as I’d like. However, whenever I do, the questions are always there.
Yesterday the question was posed:
Why do we not include debt service into the cap rate? After all, if the cap rate is supposed to measure the rate of return on the investment, and debt service obviously goes against the cash flow, why not include it?
Related: How to Know What Cap Rate to Shoot For on Any Given Rental Property
Good question, so let’s talk about it.
What is Cap Rate?
This is huge, guys, so pay attention!
Capitalization rate is not a metric of investment return on a specific investment. Cap rate is a market-driven metric, which measure the attitude and behavior of all market participants. Think of it this way:
In the SFR world, in order to estimate valuation of property, we do something called comparative market analysis — CMA for short. What CMA does is it looks at like properties that closed and makes adjustments to all of those “comps” to guesstimate what the value of subject may be. In the SFR world, there is no mention of income in the value-setting mechanics. All we do with CMA — and by “we,” I mean banks and appraisers — is consider what people have been willing to pay for SFR and then discount or inflate based on amenities to arrive at likely value of the subject.
This is pretty straightforward. Because these houses are designed not as income assets but as shelters, the appraising mechanics make no mention of anything having to do with income.
At least in its most basic form, income property is purchased for its income, which means that the value of the property is in some way pegged on its income. And because this is so, simply looking at the sales price of a comp tells us nothing. What we really want to know is how this sales prices was pegged to the income — we are interested in that relationship between the income and the price.
This relationship, when represented with a coefficient, is the CPA rate. So, if we are able to analyze the income of an asset and juxtapose it to what someone paid for the property, we can arrive at a representation of how much they thought the income was worth, in this asset class, in this marketplace.
For example, if you know that some paid $100,000 for a 4-plex, and you know that said 4-plex generated $10,000 of income, then you know that the buyer was looking for a 10% return — $10,000 is 10% $100,000.
In the above example, when I say “income,” what I really mean is net operating income — NOI. The NOI is what’s left of gross potential income after the economic losses and all other operating expenses (OpEx).
Important to note is that OpEx does not include debt service!
Simple, if you think about it. The debt service is a function of the financing structure in the deal. One person may pay cash, in which case he would not have any debt service, while someone else may finance 100 percent — and everything in between.
As such, the debt service is personalized to the investor and is not an asset-specific cost. And in that we want to compare apples to apples, we only focus on OpEx, which in equal measure applies to all potential buyers.
Of course, the debt service, whenever there is debt, must be subtracted from the NOI in order to arrive at the cash flow. And to calculate investment returns relative to your cash investment, you must use either COC or IRR, of which IRR is much more dynamic.
Cap rate is not a metric of return on a specific asset. Cap rate illustrates how the marketplace as a whole values income!
Investors: Have any questions about how these calculations work?
Leave a comment, and let’s talk.