Real Estate Deal Analysis & Advice

The Truth About Cap Rate: 5 Myths—Busted

Expertise: Commercial Real Estate
18 Articles Written
TRUE versus FALSE written on the white arrows, dilemmas concept.

A lot of what you read about cap rate is simply wrong. I'm here to dispel the myths and tell you the real story.

Perhaps no topic is more overrated, misunderstood, or debated than cap rate. I would also argue that cap rate has more inaccurate or misinformed articles written about it than pretty much any other topic on real estate, but no one wants to listen to me argue.

Instead, why not just forget everything you’ve read about it, and start from scratch here?

Cap Rate Definition

Cap rate is short for “capitalization rate,” which is a mathematical formula used by appraisers to measure the value of income-producing real estate. Because it’s impractical to compare one income-producing property to another the same way you can with tract homes, a different method was needed to gauge value. Cap rate became the most widely accepted measurement.

Cap rate is calculated by dividing the net operating income (NOI) by the property’s purchase price (or sale price, depending on which side of the table you are sitting on).

For example, if the property produces $100,000 of NOI and is purchased for $1 million, the cap rate is 10%. If the purchase price is $2 million, the cap rate is 5%.

NOI is income minus operating expenses. Debt service payments and capital improvement costs are ignored for the purpose of this calculation.

NOI / (Purchase Price) = Cap Rate

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$100,000 / $1,000,000 = 10% Cap Rate

Commercial real estate investors have an odd love affair with cap rate, which leads to all sorts of opinions on what cap rate is and what it means for their investment strategy. Here’s a list of some common statements I hear and read about cap rate:

  • “Cap rate is equivalent to the return I receive if I pay cash for the property.”
  • “I need to buy at a high cap rate to get the returns I’m looking for.”
  • “A high cap rate means I’m getting a better deal.”
  • "If interest rates rise by 1%, cap rates have to increase by 1%, too."
  • “I bought the property at a 5% cap rate and turned it into a 10% cap rate!”

What do these five statements about cap rate have in common?

They are all wrong. Yes, every one of them.

Myth Busted: The All-Cash Return

I wish people would stop saying, “Cap rate is the return you get if you paid all cash.” It is not.

word myths on colorful wooden cubes

Here are two ways that this is wrong:

I once bought a property that was around 300 units. The previous owner had their eye completely off the ball and hadn’t kept their rental rates up with the market. The day we closed escrow, our new management team arrived at the office to take over. Each time a new prospect walked in the door, we raised the quoted rent $25. We did this all day until the first person said no.

It took five prospects, so we immediately had a $125 increase in new leases on the first day. It would only be a matter of time before the entire property cycled to the higher rate.

Did that affect our return? You bet it did. So much for cap rate telling us anything about our expected return.

Even if we hadn't done that, to buy the property, we would have needed to inject additional cash to close the purchase. Closing costs, title insurance, legal fees, immediate capital improvements to correct deferred maintenance—you name it. The price we paid was not the cash we would spend.

Cap rate is net operating income divided by purchase price. Our purchase price was less than the cash outlay, so this misconception of cap rate fails for a second time.

Myth Busted: Higher Cap Rates Mean Higher Returns

Reflecting on our second incorrect statement about cap rate, “I need to buy at a high cap rate to get the returns I’m looking for,” consider these two examples:

Example 1: An 8% cap rate on a stabilized property in a stagnant market with no rent growth, no job growth, a slowly declining population, and no ability to push rents with renovations.

Example 2: A 6% cap rate in a market with above-average population growth, job growth, and income growth with stable occupancy and high rent growth. The property is underperforming relative to nearby comps. With some minor cosmetic improvements, rents can be increased 20% on each unit that is rented to a new resident in upgraded condition.

In nearly every case, over the long-term, example 2 will outperform example 1 despite example 1’s higher cap rate.

Related: Cap Rate: The Not-So-Obvious Things You Need to Know

Myth Busted: High Cap Rates Mean a Good Deal

“A high cap rate means I’m getting a better deal.” This statement by itself is false.

Our examples above illustrate this point across two different markets, but even within the same market you could have a property selling at an 8% cap rate that could be a worse deal than another property in the same market selling at a 6 percent cap rate.

Example 1: An 8% cap rate on a 50-year-old property in which all the interiors have been recently renovated and the seller has pushed the rents to $25 higher than the comps. The property doesn’t need a thing; it is totally turnkey.

Example 2: A 6% cap rate on a 20-year-old property that hasn’t been touched since it was built, except that the owner just put on a new roof. Interiors are original, rents are $150 below market, and renovated comps are getting $100 more than the non-renovated comps.

Example 2 is more likely to be a better deal despite the lower cap rate. There's nothing you can do to push the income in example 1; it's been pushed as far as it can go. And example 1 is 50 years old. So despite the upgrades, the maintenance bills are likely to increase substantially over time. There could also be big-ticket items in your future, such as a new roof, foundation repairs, new windows, and new heating and cooling systems. The list goes on and on.

But in example 2, you have multiple opportunities to increase income. The low-hanging fruit is just bringing the rents to market rate, in line with non-renovated comps. Then you have the option to go to the next level by performing minor interior cosmetic improvements to push rents further toward the level of the renovated comps in the area.

Myth Busted: Rising Interest Rates Mean Rising Cap Rates

It is often thought that cap rates move when interest rates move. You might hear people say things like, “If interest rates rise by 1%, cap rates have to increase by 1%, too.” There are two concepts at play that give people reason to believe this.

dictionary entry of the word lie highlighted in pink

Investment return

The thinking is that if someone can invest in risk-free treasury bonds at 3% interest, why would they invest in real estate at a 4.5% cap rate? There isn’t enough of a risk premium to justify investing in real estate at such a low yield.

Hopefully by now you already see why this argument is a red herring. Cap rate is not a measurement of investment return; it is a measurement of market sentiment. Under the right conditions, it’s entirely possible to capture a 20% return from a 4% cap rate property. As a result, comparing risk-free yields to real estate cap rates is like comparing airplanes to submarines.

Borrowing costs

The thinking here is that if interest rates rise, it costs more to borrow money. Therefore, you have to buy at a correspondingly higher cap rate in order to preserve investment returns. There are two reasons why this usually isn’t true.

First, the debt represents only a portion of the purchase price, such as 65-75%—and in many cases even less—and the remainder of the purchase price is cash. This mutes the effect of a higher interest rate on the borrowed money to some extent.

Second, if interest rates are increasing, it is also likely that the economy has momentum and perhaps inflation. Rents tend to rise during inflationary times, which in turn increases the income from the property—perhaps to an even greater extent than the increased borrowing cost takes from it.

The bottom line is that cap rates compress and decompress at the whim of market sentiment. When real estate becomes less popular, prices go down, which means cap rates go up. When real estate is highly sought after, prices go up, which means cap rates go down.

Cap rates can also move when outside factors alter investment returns. For example, if rent growth slows or operating expenses go up, the only way to achieve the same desired investment return is to pay a lower price for the property, which means buying at a higher cap rate. Interest rates are only one of the many inputs in solving for returns. Higher borrowing costs will certainly have an effect, but interest rates and cap rates don’t move precisely in parallel.

Related: How to Calculate Cap Rate (& Where Many People Get It Wrong)

Myth Busted: Forcing the Cap Rate

Here’s another funny statement I hear often: “I bought the property at a 5 cap and took it to a 10 cap!”

Someone might be inclined to boast this claim if, for example, they bought a property that historically threw off $100,000 NOI for $2 million (a 5% cap rate) and then they were subsequently able to increase the NOI to $200,000. But this claim fails from two directions.

First is that cap rate is simply a measure of market sentiment, so “taking a 5 cap and making it a 10 cap” means that they just destroyed the market and lowered their property’s value by 50%. Remember, cap rate isn’t about their property; it’s what the market is willing to pay for an income stream.

They alone can’t move the whole market, so they alone can’t move the cap rate. No matter what they did to the income later, they still bought $100,000 of historical NOI for $2 million, and that will always be a 5% cap rate.

The second reason this statement fails is that they undoubtedly had to invest capital into the property by making physical improvements to drive the revenue higher. Boasting about moving cap rate (which is calculated using only the purchase price) ignores the additional capital required to achieve the higher NOI. And of course, this says nothing of the fact that using post-acquisition NOI to calculate cap rate is bending the rules of the formula itself.

What anyone making this claim should be talking about is their yield on cost. This is similar to cap rate but more like a first cousin than a twin. To calculate it, divide the current NOI by the entire project cost, including purchase price, closing costs, sponsor fees, and capital improvements.

Using the property from the example above, let’s say that $1 million was spent on closing costs, fees, and improvements, bringing the total project cost to $3 million, and the NOI grew from $100,000 to $200,000. In this case, they could claim that they bought the property at a 5 cap and after they stabilized it, they brought the yield on cost to 6.7%.

This doesn’t sound as sexy as claiming they “made it a 10 cap,” but at least they’d be telling an accurate story.

And here’s one more thing: It is entirely possible to double a property’s income and add no value at all. In the above example, if $2 million was spent on closing costs, fees, and improvements, the total project cost would be $4 million. Doubling the NOI to $200,000 results in a 5% yield on cost. If the market cap rate is still 5%, the property is worth exactly what was spent on it—there was no value added. Even if someone claims that they “brought the 5 cap to a 10 cap”—they really did nothing at all.

Brian Burke Hands Off Investor book ad

What other myths have you heard about cap rate?

Add them in the comments below!

Brian Burke is president/CEO of Praxis Capital Inc, a vertically integrated real estate private equity investment firm, and author of
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    Ruth Lyons Realtor from Highland, MD
    Replied 3 months ago
    Great article. Thanks for sharing!
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    You're welcome, Ruth!
    Felipe Sanchez Rental Property Investor from California
    Replied 3 months ago
    Great Article. So many nuances in understanding the cap rate?
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Indeed, which is probably why it is so misunderstood.
    Michael Schmidt Investor from Atlanta, GA
    Replied 3 months ago
    Excellent article! I agree with your points. The property value may be expressed in terms of say, a 6% cap rate, but this does not mean the value is caused by investors’ wanting a 6% cap rate. It is more accurate to think of the property value, and implied 6% cap rate, as the byproduct or reflection of a more comprehensive, multi-period total return analysis.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Exactly! The cap rate is just the passenger, not the driver. How much you pay is a function of solving for your desired investment return, not just using a second-grade division problem. I'll have another article next week to dive into that more.
    Kevin Leonce Investor from Atlanta
    Replied 3 months ago
    Excellent article. One point in particular that I constantly hear individuals talk about is increasing a cap rate and they really should be using the term yield.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Yes, yield on cost, cap rate doesn't change.
    Brian Whelan Real Estate Broker from NYC Metro Area
    Replied 3 months ago
    hey Brian, this provokes a great conversation around the limitations of cap rates. In NYC investors are obsessed with cap rate because the bulk of our product is rent stabilized multifamily which saw the upside effectively removed with tightening rent laws in 2019. This meant that other metrics which we traditionally leaned on like $/sf and $/unit became less important because the income was essentially fixed. The cap rate was the one metric we had left to try and make sense of it all. If not internalized correctly CAP rate can lead to a false sense of security! I'm looking forward to reading your book, i just pre-ordered on amazon,
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    A lot of people are inappropriately obsessed with cap rate, Brian. It's crazy because it's really of little value other than just using it as a comparison of the price you are paying for an income stream relative to the price other people are paying for income streams for similar property in the same area--and then estimating how much you might be able to sell for later. Cash on cash return, equity multiple, and IRR are really the only true performance indicators.
    Jared Stasch
    Replied 3 months ago
    Strange. I just did a video blog about the same thing. Return on your investment is a lot more important than a cap rate.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Yeah, much more important! But people can get so stuck on cap rate that they can't see the forest through the trees.
    Daniel Kurkowski Real Estate Broker from Saint Paul, MN
    Replied 3 months ago
    I see what you are getting at, but a lot of this is inaccurate. I like what you are saying about cap rate not telling the full story, because there is definitely a need for metrics like IRR to tell the story of returns on investment over time. Without writing an entire article in response here are a few interesting points to consider. Cap rate in its simplest sense is a snapshot of return at a point of time which is NOI/Purchase price (or basis/value). It is also the same as the unleveraged return per CCIM. I think you would be hard pressed to consider another source the leading authority. https://www.ccim.com/cire-magazine/articles/cap-rate-calculations/?gmSsoPc=1 Another way it is used is to come up with the market cap rate. Market cap rate is the average reported cap rate at acquisition of similar assets which is used as a measure of market sentiment. These numbers can be inaccurate because they are largely self reported and as such, can be inclusive of different expenses or subject to other biases. Do you count title fees, what do you pull out for vacancy/credit loss etc. means everyones reporting is a little different. Despite this, it is still very helpful for recapitalizing income to a valuation and for measuring public sentiment (as you pointed out). It is important to note that these two definitions are two separate things. One is the measure itself and the other is the average of those measures in a market for a particular asset. Also, holding all other variables equal, rising interest rates DO mean rising cap rates. This is because a higher cost of money (interest rates) lowers demand for money (our desire to borrow). With less money in circulation competing for these fixed real estate assets, demand decreases for real estate (and financial assets). Higher interest rates also offer a safer alternative in terms of interest in your bank account, which encourages savings and decreases investment. Think about this from a common sense perspective, would you buy a 5% cap rate property if you were paying 100% interest rates to acquire it? How about 0% interest rates? The claims in this article are fundamentally unsound from an economics perspective. The interest rate argument you make is a common misconception. When interest rates are low, the economy grows and inflation increases. When interest rates are high, growth slows and inflation decreases. Anything with a high availability of cheap debt has gone up historically in price because the demand ($ available) increases but the supply stays relatively consistent. Think about healthcare, universities, real estate and other financial assets.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Thanks for your comments Daniel! I think we'll just have to agree to disagree here, I debunked most of that in the article. But, I do agree with one thing--cap rate is a measure of market sentiment. It just doesn't have a lot of other use.
    Dawn Burwell Rental Property Investor from Tarentum, PA
    Replied 3 months ago
    That was great ! Thank you for the clarity and information
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    You’re welcome, Dawn!
    Chris Wolforth Real Estate Agent from Salem, MA
    Replied 3 months ago
    Thanks Brian I really enjoyed the article! It definitely helps me understand cap rate more in depth.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Glad it helped, Chris!
    Tiago Camilo from Frisco, Texas
    Replied 3 months ago
    Very relevant points, thanks for the prespective!
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Any time, Tiago!
    Mark Stedman Investor from Nashua, NH
    Replied 3 months ago
    I agree that CAP rate is just a calculation that can be used as a general metric of financial viability of income properties, in a similar fashion as ROI is a calculation used by businesses that invest in themselves. When I bought my 17 units at 3 separate addresses, I simply calculated what I expected to yield as an annual gross, less expected and a generous allowance for miscellaneous unexpected expenses, to see what kind of returns I could expect. CAP rates can easily be manipulated upwards ( if you are selling ) or downwards (if you are buying and looking to justify a lower offer to purchase ), so its definitely not set in stone. Finally, you made a reference to risk vs reward and comparing a Treasury Bond to a CAP rate. The big apples vs oranges argument there is the differences in tax treatment. The biggest difference there being DEPRECIATION. That’s a topic in itself.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Good point about the depreciation, Mark. Very true. Addressing the manipulation of cap rate--this is a common misconception that I didn't address. Cap rate can't be manipulated. Cap rate is the historical NOI divided by the purchase price. The only way to manipulate that is to lie about the income. Putting that aside, because for the sake of discussion we can assume that you can verify income and expenses, the cap rate simply is what the cap rate is. Having said that, what DOES happen a LOT, is brokers and/or sellers stating a cap rate that is not true. They do this by using proforma income, or "normalizing" expenses. But that's not really the cap rate, that's just marketing (playing right into the people who place too much emphasis on cap rate). Kind of like saying "this car goes zero to sixty in one second," but it only does that when dropped out of the back of a cargo plane from 5,000 feet. On the ground under its own power, it'll go zero to sixty in five seconds, every single time.
    Bill F. Rental Property Investor from Boston, MA
    Replied 3 months ago
    Thanks for taking the time to write that Brian, excellent article. This should come up as a link every time someone mentions cap rate on BP! One part I'd be interested to hear your opinion on: Cap Rates are for stabilized properties, but what is the smallest size property that you have seen with stable occupancy? My thought is 25 units, but would love to hear your point of view. Also, at what occupancy level do you start to shy away from cap rate and move to other valuation metrics?
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Great question, Bill. First let's clear up a myth. Cap rate is not just for stabilized properties. Cap rate is used to measure the value of an income stream. It doesn't matter if the income is stabilized or not, the income divided by the purchase price is the cap rate. Having said that, I'd bet you my next profit split that an unstabilized income stream would sell for a far lower cap rate than a stabilized one for a similar property in the same area. By now you are probably starting to see why cap rate isn't the silver bullet that people make it out to be. People get confused because the law of mathematics allows you to reverse the calculation and divide the income by "the cap rate" and arrive at a value. But that is an improper use of the formula for the purposes of deciding how much to pay for real estate. Maybe it's fine for an appraiser to use to tell their client (the bank) how much they MIGHT be able to sell the property for if they have to foreclose (which is really all that an appraisal is doing). But for a buyer, I beg you, don't do this. To you question about size. "Standard procedure" is for cap rate to be a meaningful measurement of market sentiment for properties five units and larger. Under five units, the appropriate measure of market sentiment is price per unit or price per square foot (meaning, "comps"), or perhaps Gross Rent Multiplier. To your question about occupancy and where do I move to other valuation metrics? I never use cap rate as a valuation metric, I always use cash on cash return, equity multiple, and IRR. Cap rate serves one function, and one function only--to estimate the price that I MIGHT be able to sell the property for at a future date. But more on that next week.
    Bill F. Rental Property Investor from Boston, MA
    Replied 3 months ago
    Thanks for taking the time to answer my questions Brian, I appreciate it.
    Kellon Parkinson Investor from Utah
    Replied 3 months ago
    To make sure I understand correctly (because I also hear all sorts of mixed claims regarding cap rates), wouldn't it be better to purchase a property at a 10 cap and then sell it at a 5 cap? In contrast to "turning a 5 cap into a 10 cap," I know an investor who buys properties with a higher cap rate and later sells them with a lower cap rate. Or maybe I'm completely backwards in my understanding.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Yes, Kellon--you have this very right. But that is easier said than done. If the market cap rate for the type of property you are looking to buy is 5%, which it must be if you think you can sell it at a 5% cap rate, in order for you to buy it at a 10% cap rate, you'd have to pay 50% of it's current market value. If you can do this, DO IT, and do it as often as you can. But most people find that to be a needle in a haystack, or a once-in-a-lifetime opportunity. Others call it taking advantage of an unwitting seller. Call it whatever you want, it is very rare that you can actually buy a property for half of it's current value. Having said all of that, your friend might be misusing cap rate in some way when they make that claim, or perhaps it's more subtle, like buying at a 6 and selling at a 5.5--that's just a 9% discount from market value. That's doable if you look hard enough.
    Jordan Moody
    Replied 3 months ago
    Love this. Very helpful and it brings up some great points!
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Thanks Jordan!
    Vaughn K. from Seattle, WA
    Replied 3 months ago
    It's just one of many metrics that come into play when evaluating a deal... But it has its uses. If you're looking for income primarily, buying a property with a higher cap rate is better than buying one with a lower. You mentioned above that people don't sell properties for half their value (10% vs 5%), but people DO sell properties for less than they're worth all the time. Or different types of properties might generally sell for different cap rates. Or the same type of properties in different parts of town. Etc. So if you want income vs maybe potentially better appreciation in an up and coming neighborhood, buying a 10% cap rate building vs a 5% is where it's at. One can look at properties all day long and see infinite variance in cap rates for a lot of reasons. Sometimes just bad math, sometimes because the NOI appears better because of deferred maintenance, or a million other reasons... But as a basic metric to Yes or No properties for looking into further it can be useful.

    Also, technically several of these things are really just semantics. Going from a 5% cap rate to a 10% "cap rate" is incorrect usage of the term to be sure, but in effect one is getting the point across that they doubled the income. How much capital they had to spend should certainly be factored into that math, but people get what somebody means when they use the phrase in that technically incorrect way. It's always best to use terms correctly, but some might say playing semantic games can be a bit nit picky :)
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Like I said, cap rate is one of the most hotly debated topics in commercial real estate! I agree with a lot of your points here, Vaughn. A notable one I'll stick with is buying at a higher cap rate doesn't mean more cash flow. Maybe for the short term, but not necessarily over the long haul. I had a couple of examples in the article to support my belief, but it is true that there are exceptions to every rule and once in a while, a higher cap rate will produce more cash flow, even over the long term. Can't say I've experienced that in all of the years that I've owned real estate, but it's certainly theoretically possible. Thanks for adding to the discussion!
    Vaughn K. from Seattle, WA
    Replied 3 months ago
    Well, if you're buying a lower cap rate up front, but expect it to perform better over the long haul that requires a more rapid rise in rent prices than a building starting with a higher cap rate. That COULD happen. Or not. There is infinite variance in what happens in the real world!

    An example. Let's say that gentrification happens in 4 phases. 1 is just a random not awesome part of town, no indications it's going to get any better either. 2 is just starting to possibly be turning into maybe being a cool spot... 3 it's pretty obviously an up and coming area, and has already made major strides. 4 is a full on hipsterized area.

    Buying in a 1 area that has no current indications of getting nicer will probably provide a higher cap rate, as less good areas usually do. If it stays the same, you make good cash flow, but may not see the growth in income which you think will ultimately make other areas better over the long haul. Fair enough.

    If you buy into a 3/4 zone, you'll see lower cap rates, but maybe future growth that is better than a 1 that never goes anywhere. The "dream" is picking areas that are 1s, and owning them all the way through until they become 4s. But what about buying 2s? If you buy into a 2, it's already got increased odds it's going to become a 3/4, because it's already somewhat on its way. You're probably still getting better initial cash flow as it's not THAT nice yet, AND have more potential for future growth than buying in a 3/4 area, because it's only partially along in its hipsterization.

    Obviously there's timing issues, predicting the future correctly stuff baked into that... But it's a very common case in urban areas nowadays. Frankly I've called the order in which neighborhoods in my city got trendy pretty accurately. It was obvious to me by just looking at geography and amenities what areas would do well in the future, even if they weren't that "cool" to begin with.

    So I'd say it's more all over the map in terms of long term outcomes, not that consistently buying low cap rate areas, because they're already cool, tend to be better over the long haul. I don't think it's fair to say which will outperform either way up front just on initial cap rate.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    I think we agree here, Vaughn. If you can buy in an area right before it turns a corner, you can hit a complete grand slam. But if you have to wait a decade, you MIGHT have rolled your money over 3-4 times in the better area. Too bad we only know which is right after we look in the rear view mirror.
    Amy Pfaffman
    Replied 3 months ago
    I appreciate the clarification around cap rate, but I think people are just using the term more loosely than you like, myself included. Perhaps I'll update my language to be more technically accurate. When I'm assessing a property, I look at what I think the rent could be (not necessarily what it is now), what the purchase price is, what my annual expenses will be (taxes, insurance, management), and what I'll have to spend to get it ready to rent. ALL of those factor into my decision, and I do look at that number as a percentage. I've been calling it cap rate, but I guess I need to call it yield on investment. I'm in the process of building a spreadsheet to track total expenses for every property vs total income, keeping a running number on return. That's what I'm looking at. Cap rate as you describe it is a useless number, but maybe that's the main point you were making.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Sounds like what you are calculating is "forecasted cash on cash return". Far more valuable than cap rate, and some people even confuse the two. Your calculation is actually a measurement of investment performance, whereas cap rate is simply a measurement of market sentiment.
    Chad Carson Investor from Clemson, SC
    Replied 3 months ago
    Nice article, Brian. I think the confusion and hot debate about cap rates is mainly a vocabulary problem. It's like trying to get everyone who uses the English language to use the words exactly as defined in the dictionary and not how regular people use it. You've done a great job of explaining what cap rate technically is (a measure of market sentiment) and the short-comings of making too much of that real calculation. But the more "loose" definition of cap rate that Amy referenced in the comment above is very common among investors. It usually refers to "yield on cost" or "forecasted yield on cost," which are both useful calculations (probably one of the most useful in my own deal purchases). And as confusing as that makes things calling those cap rates, it's likely a futile crusade to convince everyone of the correct definition. For my part - when I find myself using the incorrect technical definition of Cap Rate for convenience or understanding-sake, I'm going to keep throwing the "aka a yield on cost" so that the conversation moves toward more clarity and accuracy.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    I wish I could remember who it was that used to say something like "your wealth is your vocabulary" or something similar to that. I remember it was one of the gurus at a conference somewhere about 15 years ago when I first heard that. I think his point was that if you want to increase your wealth, increase your vocabulary and it will happen. Probably total guru BS stuff but if this really is simply a matter of vocabulary perhaps I've contributed to someone's wealth by improving it. LOL
    Chad Carson Investor from Clemson, SC
    Replied 3 months ago
    Words are powerful! Could be true. If you can understand the nuances of a definition and apply that knowledge to your investing, you're probably going to do better.
    Thy Dinh
    Replied 3 months ago
    Thanks for the great article! Looking forward to reading more!!!
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Thanks Thy!
    Michael Baum from Olympia, Washington
    Replied 3 months ago
    Great article Brian. I did have a question and it seems very basic. Why is debt service not included? It seems like it is part of the cost of ownership right?
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    You're right, Michael, debt service is part of the cost of ownership. And debt service impacts returns. But remember, cap rate is not a measurement of investment performance, so the debt service is irrelevant here (instead, debt service is considered when calculating cash on cash return, IRR, and equity multiple). Cap rate is a measurement of market sentiment--simply quantifying how much people are willing to pay for an income stream. The only way to make relative comparisons is to compare apples to apples. Given that each buyer would finance the property differently, and some not at all, factoring in debt service would make cap rate unusable for it's intended purpose. Each buyer would arrive at a different cap rate for the same property.
    Mitch Messer Rental Property Investor from Atlanta, GA
    Replied 3 months ago
    Excellent post, Brian! I particularly enjoyed the examples and I'll be forwarding this to many of my colleagues. We could all use the review! For my part, I think of cap rate as being analogous to P/E ratio in the stock market: It's useful for valuing companies and to find out whether a stock is overvalued or undervalued, but out of context it offers ZERO information about the quality (i.e. return) of an investment.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Precisely!
    Raju Balakrishnan Rental Property Investor from Santa Clara, CA
    Replied 3 months ago
    Really informative post. Thank you. Regarding the way you increased the rent (ask $25 more till first person says no), seems arbitrary. you must be using some sort of market analysis and data driven methods to decide on rent, I believe.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    We do, yes, but that data didn’t prove we could go that high. So we set our own market by using the best market survey data there is—real-time prospects signing leases! Market data tells us what other people can do. Signed leases tell us what WE can do.
    Raymond Ferraro
    Replied 3 months ago
    I disagree with your myth busting approach on Cap Rate. You have mixed potential worth of a property with what it's worth the day you buy it. Present cap rate versus future improved cap rate, there's no myth to bust, it's just math. If you raise rents, improve the property or change it's use of course the cap rate changes. If you want to analyze several deals to see which one meets your objectives you might list existing cap rates and improved cap rates then make your purchase based on which deal meets your objectives and how much risk you are willing to take on to get to those future cap rates.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Unfortunately I can’t get onboard with your thesis, Raymond. I doubt we’ll get on the same page here—which is pretty common...cap rate is probably one of the most misunderstood and misapplied concepts in commercial real estate.
    Steve Morris Real Estate Broker from Portland, OR
    Replied 3 months ago
    Couple of items, bear in mind I think CapRates are unreliable based on reporting bias: 1) What numbers are they basing CapRates on? I understand its NOI/Price, but is the NOI actual I&E and rents or is it ProForma. Buyer/seller reported it or, worse yet, a broker (yes, I am one). 2) What are you comparing CapRates with? Same neighborhood, mismanaged prop (with lots of easy upside) vs well-run (not as much upside) properties. Age, condition, location, unit mix make a lot of difference in value. 3) Based on not knowing how certain NOI is, the almost best curve (assuming you have a representative sample) on a comp sale is $/SqFt. You know SqFt and price for certain. Plus it does adjust for lots of 3 beds (large sqft) or studios (small sqft). Yes, it doesn't address income and expenses. 4) I really prefer cash-cash return (CBFT/DownPayment). It accounts for a loan and the cost of money. It's also the fairest way to compare it to other non-CRE investments. It doesn't take into account risk factor or tax shelter of income.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Ahhhhh, all of the reasons why cap rate is so useless! In my view, there is only one cap rate that matters, actual NOI adjusted for post-sale taxes. If using cap rate appropriately, which is only to estimate an exit price, many of the extraneous variables are moot. Totally agree with your point #4! Cash on cash, IRR and equity multiple are the only primary performance indicators.
    James Storey Real Estate Broker from Indianapolis, IN
    Replied 3 months ago
    Brain, Great article! I am constantly having to correct those who use CAP rate as a return metric rather than a valuation metric similar to bonds. This becomes more clear when those individuals find the correlation with the capital markets with the equity markets in the Band of Investment calculations that appraisers use. Plus CAP rate should only be treated as a snap shot of the property today. It doesn't take into account any value add or rent growth in the future. I had a client purchase an apartment building for a 6% CAP but with the value add aspect, their leveraged returns on the property was well over 20% for a 10 year time frame. Thanks for clearing these up. Regards, James Storey, CCIM
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    100% James! You totally have it right. Thanks for commenting!
    Joe Scaparra Investor from Austin, TX
    Replied 3 months ago
    Ok Brain, help me out. Since these myths exist through out the real estate environment, what am I the investor to take from knowing a Cap rate. It seems "yield on cost" might be more beneficial to know for the investor than cap rate. Also, give me some common sense targets for Cap rate. Here is what I mean, the first home I bought I got a 30 yr 11.125% mortgage loan in 1984. I didn't have a clue if that was good or bad. Now I know, and I would never do that again. In this environment, I would say 3.5% 30 yr rate is fine, 5% not so much. Is it possible to put a target on Cap Rate for a small time investor that tells him/her that Cap rate is reasonable or not. It seems that your article gives too many variances that CAP rate is almost meaningless.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Cap rate is ALMOST meaningless, Joe. I wish I could tell you “buy at X% and you are good,” but I can’t say that. The examples in the article debunk any bright-line test you might try to use to extract meaning from cap rate—which was my whole point in writing the article, so many people don’t understand this. A 1% cap rate deal might throw off a higher total return than a 10% cap rate deal. All of this comes back to the fact that cap rate is not a measurement of investment performance. It’s only useful application is to estimate how much you can later sell the property for. Check out my author profile for a link to my follow-up article that dives into this concept. As for deciding if you are getting a good deal, or not, you’ll want to use IRR, cash on cash return, or equity multiple. The idea is that you are looking to hit the performance that is meaningful to you depending on your investment goals. For example, if cash flow is most important to you, a “good deal” is one that throws off a cash on cash return that meets your objectives. If you are a growth investor, you would be solving for a meaningful IRR or multiple.
    Cedric Van Duyn Rental Property Investor from Gig Harbor, WA
    Replied 3 months ago
    Thank you so much for the clarity on the nuances. It makes sense that if you use the Cash Flow on the property to improve the NOI then you are doing so at a loss to your NOI. Hence, "yield on cost" is more technically accurate. However, if you were not depending on the Cash Flow and do not have other investors to pay back, then it is not as consequential... You used the income from the property to increase your future Cash Flow and the value of the property for future disposition. The point is just that it did in fact cost you something. Correct? This is definitely a deeper level of property performance calculation which was fuzzy to me before. Thanks again!
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    You are on to something here, Cedric, but your approach is backwards. Funding improvements from cash flow isn’t the issue (and it comes from cash flow, not NOI because NOI is operating income so it excludes non-operational costs). The issue is actually that if you fund improvements from additional equity you are investing more dollars in. Yield on cost is relevant not because of the hit to cash flow, but because of the increase to “cost.” You are increasing the denominator.
    Prasanth Bugga
    Replied 3 months ago
    Then based on what we should consider whether this property is good or bad ?....pls do respond
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    IRR, cash on cash return, and equity multiple. Check out my follow-up article on cap rate (link on my author page).
    Tony Kohnle from Mount Pleasant, South Carolina
    Replied 3 months ago
    Excellent article and follow up. As an appraiser I can confirm that a Cap Rate is merely a ratio of price to income and and indicator of investor sentiment. While it can be useful as a starting point in estimating total income or return, that takes much more information and analysis. I sometimes try to explain it as similar to the dividends you get from stocks. Say you buy a stock for $100 that paid $5 in dividends last year. That’s a 5% cap rate. If the business is up or down a little bit then you could get $4 or $6 next year. That will effect your overall return which is specific to you and that stock, but may or may not effect what you can sell it for. It’s not an exact analogy but often turns on a light. Also let’s say we look at 3 sales comparable and one sold at a 4.5 cap, one at 5, and one at 5.5. The differences could be due to many factors including buyers different expected income/resale growths due to management or strategies, timing (like in a tax differed exchange, or just plain negotiation strengths or weaknesses. As appraisers we weigh these, and choose a cap rate for our subject that best reflects the overall market. Smart users/underwriters know however that they are just an indication of a reasonable expected price at that point in the market, and not a guarantee of any particular return.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    Exactly, Tony. Not to even mention the impacts of financing, below-market rents, renovation bumps, the list goes on and on.
    Mark Broadway Real Estate Agent from Springfield, MO
    Replied 3 months ago
    Excellent article. I've talked for years especially about cap rates being a 'barometer' of things and not the 'end all to be all'. Great examples showing how they can be used to determine good vs great deals long term for investors. Gotta look at the big picture of the property and market.
    Brian Burke Investor from Santa Rosa, CA
    Replied 3 months ago
    That's right, Mark. Sometimes people get tunnel vision on cap rate and then can't see the forest through the trees.
    Jordan Radke Rental Property Investor from Bellingham, WA
    Replied 2 months ago
    I've heard people talking on the BP podcast about lowering CAP rates and how it is beneficial but I'm having trouble understanding. Isn't a higher CAP rates desirable?
    Brian Burke Investor from Santa Rosa, CA
    Replied 2 months ago
    Not necessarily. Cap rates might be high in a certain area because the area is a war zone, or has no anticipated rent growth, etc. Cap rate is irrelevant except that it should be within a reasonable range of the cap rates of recent trades for similar property in the same area.
    Anish Tolia Investor from Singapore
    Replied 13 days ago
    Hi Brian. Your latest webinar pointed me to this blog that I had not seen before. The only "misconception" I had about CAP rate was that is equal to the return for a cash purchase. I think that is still true..at the point of time of the purchase. If I did no improvements or changed rent or anything then that would be the return at that point in time. I take the point about adding in all acquisition costs to the purchase price but usually that only moves the numbers slightly. And yes cap rate is simply what the market is willing to pay for a given income stream at a fixed point in time. And we should not be using cap rates to value single family homes.
    Brian Burke Investor from Santa Rosa, CA
    Replied 12 days ago
    Indeed, Anish, you are correct--and the effect of closing costs (only) is minimal. BUT, who buys a property and does absolutely nothing? Surely you'll raise rents, even if just to follow the trend of the market, right? So perhaps you are correct and the cap rate equals the return on an all-cash purchase (disregarding closing costs) but only until the day that you raise the first tenant's rent. :) So true, yes, but useful, not so much.
    Brian Geiger Rental Property Investor from Phoenix, AZ
    Replied 3 days ago
    Hi Brian, Interesting Article!! I also finished reading the "Hands-off Investor" and I enjoyed that as well. I have a question regarding your article. I agree with everything you said about CAP Rates however if CAP Rates is so misunderstood, What is the best way to evaluate a deal? I believe you hinted on some of these metrics in your statement (population growth, rental demand etc). I think Cash on Cash and Internal Rates of Return may play a role here but I'm curious to hear what you have to say on this. Thanks again for the read and your wisdom, Brian G.
    Brian Burke Investor from Santa Rosa, CA
    Replied 2 days ago
    Yes...cash-on-cash, IRR, and equity multiple are the primary measures of performance. Cap rate isn’t a measurement of performance at all—but you’ll need to have a sense of an appropriate cap rate in order to estimate the future sale price, which is needed in order to calculate IRR and equity multiple.