Minnetrista, MN · Member since 2019 · 29 posts · 21 votes
I've read about cap rate, heard it discussed on the podcast, but still don't have a grasp on it. How would you explain it to a new guy, using small words?
"Layman's terms. None of that inside, b******* jargon that nobody understands." -Mr. Shirley, Christmas Vacation
Contractor · Nashville, TN · Member since 2014 · 1k+ posts · 1k+ votes
6y
It's a way to measure how much money a rental property makes in comparison to how much money the property is worth. It makes it easier to compare assets to each other. Ignores financing since that can skew ROI.
to calculate cap rate: take the net profit for the year (ignore financing costs like mortgage payments), divide that by price of the property.
if a rental makes 6k and cost 100k, cap rate is 6%.
its useful because a $1m property making only 6k per year would be a low performing asset, while a 100k house is doing fine. It puts them on the same level to compare how good they are.
Investor · Topeka, KS · Member since 2015 · 1k+ posts · 1k+ votes
6y
It is how much profit you make divided by the purchase price (it assumes you pay all cash for the investment and have no debt.)
So if you buy a rental home and over a period of time you average $10k a year in profit and you paid $100k for the property, $100k devided by $10k = a cap rate of 10.
Contractor · Nashville, TN · Member since 2014 · 1k+ posts · 1k+ votes
6y
It's a way to measure how much money a rental property makes in comparison to how much money the property is worth. It makes it easier to compare assets to each other. Ignores financing since that can skew ROI.
to calculate cap rate: take the net profit for the year (ignore financing costs like mortgage payments), divide that by price of the property.
if a rental makes 6k and cost 100k, cap rate is 6%.
its useful because a $1m property making only 6k per year would be a low performing asset, while a 100k house is doing fine. It puts them on the same level to compare how good they are.
Handyman · Pittsburgh, PA · Member since 2018 · 5k+ posts · 13k+ votes
6y
There's a clue in the actual words. A capitalization rate measures how fast, in terms of annual percentage rate, a property capitalizes (pays) for itself. For instance, a property with a 10% capitalization rate will pay for itself in ten years. A property with a 20% capitalization rate will pay for itself in five years.
It is an apples to apples measure to compare different types of investments. However, it is a very misleading financial indicator becaue it does not factor in any other type of return outside of the net opperating income of a property. If you look at what major investment shops target they will focus on properties that have unbelieveably low cap rates for a small investor. So it is not the end all be all for making decisions, espically when you factor in the non linear gains to be made by lowering the cap rate.
Investor · Topeka, KS · Member since 2015 · 1k+ posts · 1k+ votes
6y
Why would an investment shop focus on low cap rate properties? That simply means you are paying more for the net income you receive, thus making less on your investment. In addition, no one can lower the cap rate of their property the cap rate is set by the market. It is what the majority of investors are willing to pay for the expected NOI.
I may not have been understanding what you were saying. if so I apologize.
It is an apples to apples measure to compare different types of investments. However, it is a very misleading financial indicator becaue it does not factor in any other type of return outside of the net opperating income of a property. If you look at what major investment shops target they will focus on properties that have unbelieveably low cap rates for a small investor. So it is not the end all be all for making decisions, espically when you factor in the non linear gains to be made by lowering the cap rate.
@Jacob Sampson when you work at the instutional capital level there are more important goals than pure cashflow. You asked why investors would focus on low cap rate properties, well the reason is stability. When you buy a property at a 3.5 or 4% cap rate the appreciation returns you get on a .5% change in the cap rate are very outsided when compared to a cap rate of 10%. Also if you have a cap rate of 3% for a property that has an NOI of 10 million dollars per year and you are able to add 1 million dollars a year to that NOI your appreciation returns are non linear but rather more geometric. The game of instutional capital is not necessiarly about cash flow, their goals are different, how they get compensated is different so cap rate is not necessairly a good baseline of financial analysis.
@Jacob Sampson when you work at the instutional capital level there are more important goals than pure cashflow. You asked why investors would focus on low cap rate properties, well the reason is stability. When you buy a property at a 3.5 or 4% cap rate the appreciation returns you get on a .5% change in the cap rate are very outsided when compared to a cap rate of 10%. Also if you have a cap rate of 3% for a property that has an NOI of 10 million dollars per year and you are able to add 1 million dollars a year to that NOI your appreciation returns are non linear but rather more geometric. The game of instutional capital is not necessiarly about cash flow, their goals are different, how they get compensated is different so cap rate is not necessairly a good baseline of financial analysis.
@Jacob Sampson I am happy to explain it. I come out of that word and now I am expanding my reach in the industry to technology and capital lending. When you get to the properties that are 3 plus standard diveations from the norm you are starting to get into the territory where the traditional thinking about how to invest starts to break down. Feel free to reach out if you have any other questions.
Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes
6y
Think of cap rate like the interest rate on a bank CD. If the cap rate is 10%, that means if you invested $100,000 cash to buy a property you will get $10,000 return in the year.
Most people don't pay cash. It is just a uniform way to compare different investments.
Generally speaking when a real estate market is hot, you can expect cap rates to compress.
When you see cap rates at 3-4%, it a sign of market over-exuberance. People are banking on future appreciation, rather than current return.
On the flip side when you see cap rates approaching 10%, it could be a sign of a distressed property or inaccurate reporting of income and expense.
If cap rates are moving higher on everything, it is a sign of a slowing real estate market.
Be careful because when people are selling properties, they will often misrepresent cap rates by inflating income or ignoring expenses. Never trust a number that is provided by the seller, until you review their books.