{"id":74911,"date":"2015-09-18T11:00:08","date_gmt":"2015-09-18T17:00:08","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=74911"},"modified":"2021-03-16T11:45:09","modified_gmt":"2021-03-16T17:45:09","slug":"2015-09-18-guide-calculate-understand-use-cap-rate","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2015-09-18-guide-calculate-understand-use-cap-rate","title":{"rendered":"The Investor&#8217;s Complete Guide to Calculating, Understanding &#038; Using Cap Rates"},"content":{"rendered":"<p><span class=\"leadstyle-fontsized\">Buying cash flow properties is one of the greatest ways to build wealth. To do this right, you have to buy smart. Run your numbers, that\u2019s what we say. But how do I exactly do that? This is what we are going to explore. A good way to do this is to determine the Capitalization Rate of the property (Cap Rate in short).<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><strong>Capitalization Rate<\/strong>\u00a0is a crucial indicator for real estate investing because it measures the rate of return on your investment, i.e. how much you get for your money\u2019s worth. However, surprisingly, this concept is often misunderstood within the investment circle. If you ask 10 people what the Cap Rate is for a particular property, nine out of the 10 people will give you a different answer. The last one\u00a0will ask, &#8220;What is cap rate again?&#8221;<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Jokes aside, the aim of this article is to clearly define what Cap Rate is all about, how and when you will use Cap Rate to analyze your deal, and why different people calculate Cap Rates differently. Learning to calculate and understand Cap Rate is a powerful tool for your real estate investing career.<\/span><\/p>\n<h2><span class=\"leadstyle-fontsized\">What is Cap Rate?<\/span><\/h2>\n<p>In plain English, Cap Rate can be described as such:<\/p>\n<p><em>If you purchase an investment property ALL IN CASH, for each $100 you put in, how much is your profit per year after you have paid your expenses?<\/em><\/p>\n<p>The keywords are: \u201ccash,\u201d \u201cprofit per year,\u201d and \u201cafter expenses.\u201d<\/p>\n<ul>\n<li>CASH: It assumes cash, i.e. we don\u2019t consider how a mortgage may change our return.<\/li>\n<li><span class=\"leadstyle-fontsized\">PROFIT PER YEAR: It assumes there is regular income generated from this property.<\/span><\/li>\n<li><span class=\"leadstyle-fontsized\">AFTER EXPENSES: It assumes there are expenses being associated with this property.<\/span><\/li>\n<\/ul>\n<p>Often, Cap Rate is represented in percentages. For example, instead of saying Property A\u2019s Cap Rate is $7.50 per $100 invested, we will just say Cap Rate is 7.5%. It means the same thing.<\/p>\n<h2>How is Cap Rate Used?<\/h2>\n<p><span class=\"leadstyle-fontsized\">Cap Rate is mostly used to compare income-producing properties. It gives a unified gauge for you to compare, even if the properties are somewhat different.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">For example,<\/span><\/p>\n<h3><span class=\"leadstyle-fontsized\">Scenario 1<\/span><\/h3>\n<p><span class=\"leadstyle-fontsized\">Property A: 2 units, rent = $2000\/mo, selling for $250,000<br \/>\nProperty B: 3 units, rent = $2500\/mo, selling for $300,000<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">It is quite difficult to determine which one is a better deal. Looking from a purchase price per unit standpoint, Property B seems cheaper ($100,000 vs. $125,000), whereas looking from a rent per purchase price standpoint, Property A looks better (8 per thousand vs. 7.667 per thousand). We don\u2019t know what the associated expenses are for each property, further clouding our judgment.<\/span><\/p>\n<p><em><strong>Related:<\/strong> <a href=\"https:\/\/www.biggerpockets.com\/blog\/2015\/06\/17\/cap-rate\/\" target=\"_blank\">Cap Rate: How to Best Evaluate &amp; Interpret a Property\u2019s Numbers<\/a><\/em><\/p>\n<h3><span class=\"leadstyle-fontsized\">Scenario 2<\/span><\/h3>\n<p><span class=\"leadstyle-fontsized\">Say the same two properties have the following Cap Rates:<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Property A: Cap Rate = 7%<br \/>\nProperty B: Cap Rate = 7.5%<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">It is clear that Property B is better because having a 7.5% return is better than a 7% return. We also know that all major items such as incomes and expenses are incorporated into the analysis.<\/span><\/p>\n<h2>Limitations of Cap Rates<\/h2>\n<p><span class=\"leadstyle-fontsized\">Before we start saying, \u201cOh, great\u201d and go hunting for all properties with the highest Cap Rates, here is a small caution. We cannot simply look at this number to evaluate a deal. There are two reasons for that.<\/span><\/p>\n<h3><span class=\"leadstyle-fontsized\">It\u2019s Not Just About the Rent<\/span><\/h3>\n<p><span class=\"leadstyle-fontsized\">First, Cap Rate assumes there is regular income (rent) being generated from the property. However, not all real estate is income-producing, and it can be good investment as well.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">A good example is raw land. While raw lands do not generate at the moment, some investors purchase such lands and wait for the market to go up before selling or developing them.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Another example will be homes that are predominantly used for personal uses rather than\u00a0rentals. They tend to be single-family homes in high price points neighborhood such as Beverly Hills in Los Angeles, Coral Gables in Miami, and Manhattan Upper East Side in New York. Think of the houses that you see on TV show \u201cMillion Dollar Listing.\u201d The values of these properties are not mainly driven by the rents they could command, but rather by how emotionally attached a prospective owner is to buying the house.<\/span><\/p>\n<h3><span class=\"leadstyle-fontsized\"><strong>Price Appreciation<\/strong><\/span><\/h3>\n<p><span class=\"leadstyle-fontsized\">Secondly, Cap Rate does not capture an important factor: future price appreciation of a property. Cap Rate focuses on present income and expenses, but does not consider any future growth or decline of the neighborhood. Which deal do you think is a better deal: a house with a Cap Rate of 8% but in a town where people are leaving due to job loss and crime, or another house with a Cap Rate of 6% but where the city is thriving and house price increases by 10% each year? The first house may sound better, but if you consider house appreciation as well, the second one is definitely a better option.<\/span><\/p>\n<h2><span class=\"leadstyle-fontsized\">When Should Cap Rate Be Used?<\/span><\/h2>\n<p><span class=\"leadstyle-fontsized\">In general, Cap Rate is most useful in areas where the majority of houses are occupied by renters rather than homeowners. Most houses in such areas tend to be multi-family housing (e.g. 2-family, 3-family, 4-family, etc.).<\/span><\/p>\n<h2><span class=\"leadstyle-fontsized\">How Do I Calculate Cap Rate?<\/span><\/h2>\n<p><span class=\"leadstyle-fontsized\"><em>This section is very detailed. Feel free to skip this section for now and get back to this once you understand the big picture.<\/em><\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Here is an example. This is based on one of the properties that I own. I rounded up some numbers to make the calculation easier.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Let\u2019s revisit what Cap Rate means.<\/span><\/p>\n<hr \/>\n<p><span class=\"leadstyle-fontsized\"><em>If you purchase an investment property ALL IN CASH, for each $100 you put in, how much is your profit per year after you have paid your expenses?<\/em><\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><em>(Note: Profit is simply Income minus Expenses.)<\/em><\/span><\/p>\n<hr \/>\n<p><span class=\"leadstyle-fontsized\">Here are the numbers:<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><strong>Income<\/strong>: $3,200 per month. It is a 2-family home. One tenant pays around $1,200 per month and the other $2,000. So the total income is $(1,200 + 2,000) = $3,200 per month.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><strong>Expenses<\/strong>: $1,950 per month. For expenses, the expenses that I account for are $1,950 per month in total. They consist of rent loss due to Vacancy, Property Management Fee, Maintenance Fee, Property Tax, Utilities Fee, Insurance etc. Note that mortgage is NOT part of the expenses. (Remember, the calculation assumes the property is purchased ALL IN CASH.)<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><strong>Profit<\/strong>: $15,000 per year. Since each month I collect $3,200 per month and pay $1,950 per month, there is $(3,200 \u2013 1,950) = $1,250 per month in profit. This is equal to $(1,250 x 12) = $15,000 per year.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><strong>Cap Rate<\/strong>: 7.5%. I paid $200,000 for this property and receive $15,000 in profits each year. For each $100 that I invest in this property, I receive $7.50 in return each year. Therefore, Cap Rate is 7.50% ($7.50 = $100 x 15,000 \/ 200,000).<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><a href=\"http:\/\/i2.wp.com\/realestatedoer.com\/wp-content\/uploads\/2014\/10\/Screen-Shot-2014-10-13-at-2.11.05-AM.png\" target=\"_blank\" rel=\"noopener\"><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter wp-image-105\" src=\"http:\/\/i2.wp.com\/realestatedoer.com\/wp-content\/uploads\/2014\/10\/Screen-Shot-2014-10-13-at-2.11.05-AM-300x237.png?resize=400%2C316\" alt=\"Screen Shot 2014-10-13 at 2.11.05 AM\" width=\"400\" height=\"316\" title=\"\"><\/a><\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Next, let&#8217;s look at how I come up with these numbers.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">For\u00a0<strong>Income<\/strong>, it\u2019s pretty simple. These are my actual rent figures.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">If you don\u2019t know the actual rent, the best way to get the numbers is either by talking to rental agents for their estimates or going online (Craiglist and Zillow are often good sources) to see how much similar places are being rented out for. Based on my experience, I find that it is the\u00a0bedroom count, not the finishing\u00a0of the apartment, which mainly determines the rent. This is especially true for government-subsidized (Section 8) housing. (That being said, better quality housing attracts better tenants, which is equally if not more important, but we stray away from the topic\u2026)<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><strong>Expenses<\/strong>, things like Property Taxes, Utilities, and Insurance, can easily be verified from the city office or service providers. Call your insurance broker, electric\/water companies, and your city office. A lot of people think the expense numbers are very hard to find, but they are easier than you think. They are nearly always fewer than two calls away from getting the information that you need. Most of them are online anyway. Once you have found out a few, you will also become familiar with the prices in your area and will be able to do a ballpark estimate quickly. For example, for water in my town, it is roughly $50 per month per unit (so $100 per month for a 2-family house).<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Vacancy, Maintenance, and Property Management Fee are more open to discussion. The key difference between these factors versus the others (Tax, Utilities, Insurance) is that costs like vacancy, maintenance and property management fee may not be as absolute. <\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">In my example,<\/span><\/p>\n<ul>\n<li><span class=\"leadstyle-fontsized\">I do not pay $240 per month for \u201cvacancy\u201d&#8211;it is a fully occupied property.<br \/>\n<\/span><\/li>\n<li><span class=\"leadstyle-fontsized\">Nor do I regularly pay $240 a month to maintain the property&#8211;it is\u00a0sometimes more, sometimes less.<br \/>\n<\/span><\/li>\n<li><span class=\"leadstyle-fontsized\">Nor do I pay a property management fee&#8211;I do it myself.<\/span><\/li>\n<\/ul>\n<p><span class=\"leadstyle-fontsized\">If these are not regular expenses, then why am I considering them? That\u2019s because while these expenses won\u2019t happen each month, eventually these expenses will become real, and you do have to pay for them. At some point my tenant is going to move out, my toilet is going to clog, and I will be too busy to manage all the properties. They all cost money.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">By counting these so-called expenses now, I will be much more prepared whenever any surprise comes up. Instead of getting shocked each time by any major fixes that I need to pay, I have a budget that\u00a0accounts for it. As usual, a bit of preparation and planning goes a long way.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">A related question is: How do I come up with these estimates? There is no absolute certainty in these. These are the\u00a0<strong>best estimates<\/strong>\u00a0for such costs. For example, I expect I lose roughly one month\u2019s rent whenever there is a tenant move-out. Since I assume a tenant usually stays for a year, that\u2019s roughly $3,200 per year. Divide this number by 12, and that\u2019s roughly $200 to $300 per month, so\u00a0I pick $240. I estimate the maintenance cost to be roughly the same. For property management fee, I know if I have to hire a property manager to do the job, around 7-10% of the rent will be allocated.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">In the example above, I use 7.5% of monthly rent for both vacancy reserves and maintenance, and 10% for property management fee. Unless the neighborhood that you are looking at is either extremely good or bad, these estimates should be similar to your area as well.<\/span><\/p>\n<h2><span class=\"leadstyle-fontsized\"><strong>Why Are There Different Cap Rates for the Same House?<\/strong><\/span><\/h2>\n<p><span class=\"leadstyle-fontsized\">Often when you ask a real estate agent for the Cap Rate, you get one number. When you ask a real estate investor, it will be a different number. Why would this be possible on the same property?<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">The answer is pretty simple. Both seller and buyer have his\/her own biases. A seller always want to bump the rate of return as attractive (high) as possible, and the buyer will do the opposite, pushing the rate as low as possible.<\/span><\/p>\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<p><span class=\"leadstyle-fontsized\">How would each achieve it? Remember we said numbers like maintenance and vacancy loss are merely estimates? Because of that, there is a huge room for interpretation\/manipulation.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">Let\u2019s use the same house and see how a seller or a buyer can change the values.<\/span><\/p>\n<p><span class=\"leadstyle-fontsized\"><a href=\"http:\/\/i2.wp.com\/realestatedoer.com\/wp-content\/uploads\/2014\/10\/Untitled1.png\" target=\"_blank\" rel=\"noopener\"><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter wp-image-108\" src=\"http:\/\/i0.wp.com\/realestatedoer.com\/wp-content\/uploads\/2014\/10\/Untitled1-300x280.png?resize=400%2C373\" alt=\"Untitled1\" width=\"400\" height=\"373\" title=\"\"><\/a><\/span><\/p>\n<p><span class=\"leadstyle-fontsized\">By altering certain assumptions, one house can have a Cap Rate that ranges from 6% to over 12%, even with the same purchase price! I won\u2019t comment who is right and who is wrong. It depends on what picture you are trying to paint. What is important to remember is:<\/span><\/p>\n<ol>\n<li><span class=\"leadstyle-fontsized\">The numbers are subject to manipulation (and people do that).<\/span><\/li>\n<li><span class=\"leadstyle-fontsized\">Choose numbers that work for you. If you pay 10% on average for property management fee, and the rent is $3000, put in $300 (10% of $3,000) as management fee expenses. Don\u2019t put in $200 to force the deal work. Use the most real numbers that you can get.<\/span><\/li>\n<li><span class=\"leadstyle-fontsized\">For buyers, don\u2019t forget to shop around for cheaper and\/or better vendors to increase your Cap Rate.<\/span><\/li>\n<\/ol>\n<h2><span class=\"leadstyle-fontsized\">Final Thoughts<\/span><\/h2>\n<p><span class=\"leadstyle-fontsized\">If you want to invest in cash flow properties, you have to learn how to use Cap Rate correctly. This article gives you a good reference of everything you need to know about Cap Rate. Good luck finding and analyzing your next deal!<\/span><\/p>\n<p><em>Investors:\u00a0Have any questions regarding Cap Rate? Want to add to the discussion?<\/em><\/p>\n<p><strong>Be sure to leave your comments below!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Buying cash flow properties is one of the greatest ways to build wealth. To do this right, you have to buy smart. Run your numbers, that\u2019s what we say. But [&hellip;]<\/p>\n","protected":false},"author":55403,"featured_media":74957,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4252],"tags":[],"class_list":["post-74911","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\/74911","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\/55403"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=74911"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/74911\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/74957"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=74911"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=74911"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=74911"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}