How to Use Cap Rates as a Rental Property Investor

Cap rate is such an easy target to pick on. And it’s no wonder given that there so much confusion, misinformation, misunderstanding, and misapplication on the definition and use of the concept.

I tried to clear some of this up in my recent article “The Truth About Cap Rate: 5 Myths—Busted.” But as the marketing folks on late night TV say, “But wait, there’s more!”

What Cap Rate Is NOT (& What It Is)

Not to beat a dead horse here, but it’s so important that it’s worth saying again—cap rate is not a measurement of investment performance or return, it is a measurement of market sentiment.

Think of cap rate as a reverse thermometer measuring the market. As the market heats up, buyers place a higher value on the income stream because they see upside, and that pushes cap rates down. This is called cap rate compression.

As the market cools off, buyers back off and are only willing to buy the same income stream for a lower price. This causes cap rates to decompress, or rise. This makes sense, because a growing income stream is justifiably more valuable than a static or shrinking one.

Cap Rates Vary Based on Several Factors

Cap rates are not uniform across markets or property types. Apartments built in 1980 in a good neighborhood might be selling at a 5% cap rate in Dallas, a 4.5% cap rate in San Francisco, and a 6.5% cap rate in Kansas City. Newer properties tend to sell at lower cap rates than older ones, and better neighborhoods command lower cap rates than war-zone neighborhoods.

This also makes perfect sense. If a property produces $1,000 per year of income, you expect fewer problems with a new property in a great area. But with an old property in a bad area, you would expect all sorts of problems.

For the same income, you are willing to pay a higher price for the newer property because you see less risk, and thus you’ll accept a lower return. For the older property, you want to pay a lower price because the higher risk means that you may or may not get $1,000 in the future—it depends on a lot more unknowns.

Sectors all have their own cap rates. In the same neighborhood, you might find apartments selling at a 6% cap rate, office buildings at 7%, industrial at 8%, retail at 9%, and hotels at 9.5%. The cap rate depends on how these sectors are performing and many other factors that affect risk and investment returns.

Where to Find Data Surrounding Cap Rates

Learning what general market cap rates are for any sector, area, and class is easier said than done. If you underwrite a lot of property and follow those properties until learning the price they sell for, you can get a feel for cap rates based on your own observations. For more macro-level data, you could turn to the Cap Rate Survey that is published by the commercial real estate brokerage CBRE twice per year and is available online for free. Or you could look at the appraisal that your lender is sure to order.

But one word of advice—deciding how much to pay isn’t as simple as dividing the property’s net operating income (NOI) by the cap rate. Your purchase price should be decided by backing into the desired investment return, not by a simple grade-school division problem.

How to Use Cap Rate Correctly

With all sorts of variables affecting cap rates, what good are they?

If used properly, cap rates are helpful for evaluating one thing and one thing only: the ultimate exit price of the property. In other words, the price you can sell the property for at the intended point of sale.

Using a cap rate that similar properties in the same area are selling for, you can forecast your approximate sale price. Truth be told, your actual exit sale price is likely to be way off of your estimate, in one direction or the other, but you’ve got to start somewhere, right?

For example, let’s say you are buying an apartment complex built in 1980, and you plan to sell it in five years. Other apartment complexes of the same vintage within a reasonable distance in similar neighborhoods are selling at a 5% cap rate. If you think that the market is going to remain the same as today, you can divide your projected year five income by 5% and arrive at an estimated sale price.

If you think that the market today is trading near a peak, and that perhaps the future is less certain, you might choose to divide your year five income by a higher cap rate, such as 5.5% or even 6%. This part is a bit art, a bit science.

Wrapping Up

Cap rate is not the driver; it is the passenger. Rather than saying cap rates went up so prices went down, it’s more accurate to say that prices went down, so cap rates went up.

Cap rate shouldn’t be the primary factor in your selection of real estate investments, nor should you set your purchase price based solely on cap rate. Cap rate is simply a way of measuring, after the price has been decided, how much you were willing to pay for the property’s income stream so that people (including you) can make relative comparisons between this acquisition and other similar acquisitions in the same area.

Cap rate is most useful for estimating the price that the property will later be sold for, so that you can estimate the proceeds from the sale. The sale proceeds will be an important part of calculating the internal rate of return (IRR) and equity multiple.

IRR, cash-on-cash return, and equity multiple—not cap rate—should be used to determine the right price to pay for the property and to decide the quality and suitability of a real estate investment.

Questions? Comments?

Let’s talk below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.