3 Reasons You Absolutely Need to Understand Cap Rate

3 Reasons You Absolutely Need to Understand Cap Rate

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Scott Hollister

Scott Hollister is a real estate investor, lender, and licensed agent in central Connecticut.

Experience
Scott began real estate investing in 2012 with a house hack after his parents lost their home in the recession. He found the BiggerPockets community and started listening to their podcasts and participating in the forums daily. In 2017, he was able to quit his job as a health teacher and become a full-time real estate investor.

With the help of BiggerPockets and reading books, Scott spends his time growing the businesses he has created, while also interviewing authors on his podcast, The Book Club Interview.

His life’s purpose is to be a great family man, live a long and healthy life, give back, and achieve financial freedom for his family. A lifetime avid outdoorsman, he is currently building his dream home on a 57-acre farm with his wife Brittany and golden retriever Penny.

As an investor, Scott specializes in rehabbing REOs by house hacking, BRRRR, fix and flip, commercial buildings, and raw land development.

As an agent, he specializes in helping clients with house hacking, investment property, creative lending, land development, and commercial property.

As a direct nationwide lender, he focuses on creating relationships with investors on fix and flips, bridge loans, and 30-year rental loans.

Education
Scott earned bachelor of science degrees in Physical Education, Human Performance, and Health from Central Connecticut State University.

Accreditations
Licensed agent in Connecticut (GHAR)
CCIM Candidate
Licensed CT Contractor

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As an investor, you will want to capitalize the income of a property to determine its investment value, understand the investment performance at a purchase price, and get a handle on the disposition of the asset.

A Certified Commercial Investment Member defines the cap rate as such: “A percentage that relates the value of an income-producing property to its future income, expressed as net operating income divided by purchase price. Also known as cap rate.”

You will need to understand three components of direct capitalization: income (NOI), cap rate, and value. If you have two of the three, then you can solve for the third.

The net operating income (NOI) is potential rental income minus vacancy, credit loss, and operating expenses. You will use the NOI to pay your debt service (if any) and your capital expenditures (some choose to put it above the NOI).

Let’s assume we are working with a $1,000,000 property that produces an NOI of $100,000. Gross income of $200K minus $100K of expenses = $100K NOI.

Related: Cap Rate: A Must-Have Number for Rental and Commercial Investors

Young Couple Lying On Carpet Invoice With Calculator

Formulas to Memorize as Real Estate Investor

  • Cap Rate = NOI / Value (100K / 1M=10%)
  • NOI = Cap Rate x Value (.10x1M = 100K)
  • Value = NOI / Cap Rate (100K /.10 = 1M)

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

3 Reasons You NEED to Know Cap Rate

1) To measure the investment performance of an asset at its purchase price. Be careful as this only considers the rate at the time of purchase, not how you will operate the property after receiving ownership.

Related: How to Know What Cap Rate to Shoot For on Any Given Rental Property

2) For investment value. This will show you the purchase price of the asset based on the NOI and given cap rate of the market. You then have to decide if it fits your investing criteria over a given hold period so you can measure your return or yield.

3) For disposition of the asset. To measure your yield over the holding period, you will want to predict the disposition cap rate—or simply put, what cap rate the building will sell for to determine sales proceeds. If you decide to hold onto the property for five years, then you will want to divide the projected 6th-year NOI by the projected market cap rate to determine what the next investor will purchase the property for.

Related: What’s the Difference Between ROI and CAP Rate?

aerial view of residential housing

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

Key Lessons

  • The cap rate is a ratio of purchase price and the first year NOI
  • It’s a good quick measure for comparison of similar assets and what they sold for
  • Very simple measure, but the simplicity limits dependability
  • It is a process to determine the value of your investment, but not your return on investment
  • Does not take into account sales proceeds (yield does)

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Confused when it comes to cap rates? You're not alone. But understanding this calculation is key for real estate investors. Here's why.