{"id":73415,"date":"2015-06-17T11:00:46","date_gmt":"2015-06-17T17:00:46","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=73415"},"modified":"2023-06-22T09:45:00","modified_gmt":"2023-06-22T15:45:00","slug":"2015-06-17-cap-rate","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2015-06-17-cap-rate","title":{"rendered":"Cap Rate: How to Best Evaluate &#038; Interpret a Property&#8217;s Numbers"},"content":{"rendered":"<p class=\"p1\">Most investing decisions come down to math. Property evaluation is too complex without it. If you really understand the benefits and limitations of the most common investment equations, you\u2019ll make better decisions, reduce your work load and be able to act quickly.<\/p>\n<p class=\"p1\"><span class=\"s1\">The best way to look at a <a href=\"https:\/\/www.biggerpockets.com\/blog\/cap-rate-real-estate\" target=\"_blank\" rel=\"noopener\">cap rate<\/a> is as a return on the value of a property. A 10% cap rate will give you 10% return on the value of the property over a single year after costs have been deducted.<\/span><\/p>\n<h2 class=\"p1\">How Cap Rates Work<\/h2>\n<p class=\"p1\"><span class=\"s1\">For many investors, cap rates are the magic bullet. It\u2019s the first thing they turn to when making decisions because it takes into account costs and income. While cap rates do give you a lot of information and help you compare properties, they also leave out a lot of information. Let\u2019s get to the math so we can better understand how it works and how to avoid common mistakes. <\/span><\/p>\n<p class=\"p1\" style=\"padding-left: 30px;\"><em><strong><span class=\"s1\">Cap Rate = Net Operating Income\/Value<\/span><\/strong><\/em><\/p>\n<p class=\"p1\"><span class=\"s1\">NOI is the gross yearly income from a property minus the expenses (does not including mortgage payments, income taxes or depreciation). <\/span><\/p>\n<p class=\"p1\"><em><strong><span class=\"s1\">Gross income:<\/span><\/strong><\/em><\/p>\n<ul>\n<li class=\"p1\"><span class=\"s1\">Total of all rents and other income the property produces in a year<\/span><\/li>\n<\/ul>\n<p class=\"p1\"><em><strong><span class=\"s1\">Costs include:<\/span><\/strong><\/em><\/p>\n<ul>\n<li class=\"p1\"><span class=\"s1\">Vacancy loss (how much rent will you lose in an average year due to vacancies)<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Routine maintenance (yard work, painting, etc.)<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Property management fees<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Property taxes<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Advertising<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Utilities that you pay for<\/span><\/li>\n<\/ul>\n<p><em><strong>Related:<\/strong> <a href=\"https:\/\/www.biggerpockets.com\/blog\/2015\/01\/24\/invest-rental-property-6cap-rate-reit-8return\/\" target=\"_blank\">Investment Face-Off: Rental Property With 6% Cap Rate vs. REIT With 8% Return<\/a><\/em><\/p>\n<h3 class=\"p1\"><a href=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/cap-rates.jpg\" target=\"_blank\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-73433\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/cap-rates.jpg\" alt=\"cap-rates\" width=\"702\" height=\"336\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/cap-rates.jpg 702w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/cap-rates-300x144.jpg 300w\" sizes=\"auto, (max-width: 702px) 100vw, 702px\" \/><\/a><\/h3>\n<h3 class=\"p1\"><span class=\"s1\">Example<\/span><\/h3>\n<ul>\n<li class=\"p1\"><span class=\"s1\">Property is valued at $250,000<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Rental income = $18,000 a year<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Vacancy loss averages 2% for your area = $18,000*.02 = $360 a year<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">All expected maintenance = $1,200 a year<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">No property manager, advertising or utility bills for this property<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Property taxes = $3,000 a year<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Cap rate = ($18,000 &#8211; $360 &#8211; $1,200 &#8211; $3,000)\/$250,000 = 0.054 or 5.4% cap rate<\/span><\/li>\n<\/ul>\n<h2><span class=\"s1\">How to Interpret Your Cap Rate<\/span><\/h2>\n<p class=\"p1\"><span class=\"s1\">Cap rates are different everywhere you go. Because value (price) is part of the equation, cap rates are based on supply and demand in your local area. In the U.S. most real estate falls in the 5%-10% range. It is possible to do better, but it usually requires <a href=\"https:\/\/www.biggerpockets.com\/blog\/2015\/04\/22\/forced-appreciation-buy-and-hold-investing\/\" target=\"_blank\">creative thinking<\/a>. <\/span><\/p>\n<p class=\"p1\"><span class=\"s1\"><b>Cap rates have three important uses.<\/b><\/span><\/p>\n<ul>\n<li class=\"p1\"><span class=\"s1\">The cap rate can help you understand if a property is priced too high or low for an area. All you have to do is compare the cap rate from the property you are looking at to the average cap rate for the area.<span class=\"Apple-converted-space\">\u00a0<\/span>An above average cap rate for an area can be an indication of problems with the property.<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">If you decide you won\u2019t do a deal unless you get a certain cap rate, then you can use it to decide what price to offer. <\/span>\n<ul>\n<li class=\"p1\"><span class=\"s1\">If you know the average NOI (cash flow) for this deal is going to be $30,000 a year and you will only do a deal with a cap rate of 8% or higher, then you should bid $30,000\/.08 = $375,000 or less.<\/span><\/li>\n<\/ul>\n<\/li>\n<li class=\"p1\"><span class=\"s1\">If you know what cap rates are common in the area and and you know the asking price, you can get an idea of the Net Operating Expenses assuming cap rates were used to price the property. <\/span>\n<ul>\n<li class=\"p1\"><span class=\"s1\">If the average cap rate in the area is 6% and the asking price is $300,000, then 0.06*$300,000 = $18,000 in expenses for the year. <\/span><\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<p><em><strong>Related:<\/strong> <a href=\"https:\/\/www.biggerpockets.com\/blog\/2014\/05\/10\/cap-rates-cash-cash-returns-explained\/\" target=\"_blank\">A Definitive Guide to Understanding Cap Rates and Cash-on-Cash Returns<\/a><\/em><\/p>\n<h2 class=\"p1\"><span class=\"s1\">Cap Rate Limitations<\/span><\/h2>\n<ul>\n<li class=\"p1\"><span class=\"s1\">Cap rates will not help you evaluate appreciation (increase in value) or any changes that take place over time. Cap rates are a snapshot of right now only. <\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Cap rates are based on very few inputs. A small error can significantly change the results. <\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Cap rates do not take into account loans used to purchase the property. If your interest rate is different for different properties you cannot use it to help you decide which property is better.<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Cap rates are based on guesses as to the costs and income of a property. Try to get the actual rent and cost information from the property owner. Also, check to see if they have lower than average rents or any deferred maintenance that can significantly impact your NOI.<\/span><\/li>\n<li class=\"p1\"><span class=\"s1\">Equations are only as good as the data you put into them. Make sure you&#8217;re inputting consistent average values from the area, not the values you want to see. <\/span><\/li>\n<\/ul>\n<p><a href=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/what-is-cap-rate.jpg\" target=\"_blank\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-73434\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/what-is-cap-rate.jpg\" alt=\"what-is-cap-rate\" width=\"702\" height=\"336\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/what-is-cap-rate.jpg 702w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/06\/what-is-cap-rate-300x144.jpg 300w\" sizes=\"auto, (max-width: 702px) 100vw, 702px\" \/><\/a><\/p>\n<h2><span class=\"s1\">How to Best Use Cap Rates in Analysis<\/span><\/h2>\n<p class=\"p1\"><span class=\"s1\">Think of cap rates as a compass. All they can do is point the right direction. They won&#8217;t give you any information about what lays ahead. I like to use cap rates to decide if I should spend more time evaluating a property, that&#8217;s it. Whatever you do, don\u2019t let a simple division problem decide your future. <\/span><\/p>\n<p class=\"p1\"><span class=\"s1\">Cap rates can also be used to help you decide what type of property you should invest in. If single family is going for 5%, office buildings 6% and apartments 7%, then you should probably focus on apartments.<\/span><\/p>\n<p class=\"p1\"><span class=\"s1\">Just like anything in an open market, as one type of investment gets better, demand grows, prices increase and profitability drops. Cap rates follow the same trend and can change quickly. Keep an eye on them so you always know what&#8217;s going on.\u00a0<\/span><\/p>\n<p class=\"p1\"><em>Investors: To what extent do you rely on cap rates to make your decisions about properties?<\/em><\/p>\n<p class=\"p1\"><strong>Let me know with a comment!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Most investing decisions come down to math. Property evaluation is too complex without it. If you really understand the benefits and limitations of the most common investment equations, you\u2019ll make [&hellip;]<\/p>\n","protected":false},"author":20661,"featured_media":73432,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4252],"tags":[],"class_list":["post-73415","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-deal-analysis"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/73415","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/20661"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=73415"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/73415\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/73432"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=73415"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=73415"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=73415"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}