How does the Cap Rate Work

46 Replies

So I have a single family home and a trailer that I rent out and my wife and I are looking at purchasing a triplex or quad. How does the Cap Rate work and at what time does that become relevant? I always try to learn as much as I can before making an investment and most of the forms that i've seen just say that cap Rate isn't something you have to worry about until its a commercial property. Why is this, why doesn't it matter and how does it work? 

     Any help is much appreciated, I would also like to know your experience with using Cap Rate and how it helped you in your investment, if its not to much trouble. 

   Thank you. 

Daniel ,

Cap rates are a measure of a property’s investment potential, independent of the specific buyer. With that being said, I think that would be kind of important.

I am not sure what rate of returns get you excited in moving forward, but my rule of thumb and average is 18-24% 

Go to this site and you can plug in the numbers to find the rate of return.

www.apartmentpropertyvaluation.com

Jim Sakalis

Capitalization rate  = Net Operating Income /price Essentially it is the positive cash flow you would get if you paid all cash for the property. 

In the formula above Net Operating income (NOI) is gross income-vacancy - operating expenses. Your principal and interest are not considered operating expenses for this calculation.

Traditionally cap rate is used for commercial properties and not for SFH or 1-4 unit properties. They are valued based on comparable sales. However there is no reason you cannot use cap rate on 1-4 unit properties as one measure of the financial performance of the property

The reason it is used on commercial properties is they vary so much you need a way to value and compare them. Cap rate helps do that.

Fortunately the cap rate grouch in no longer in the building so we won't have 3 pages of arguments over the issue.

@Jim Sakalis Thank you for answering so quickly, I appreciate the web page.

@Ned Carey Thank you for answering, I found a blog with the mechanics of Cap Rate. If I understand it correctly you figure out your cap rate and it gives you a percentage of profit if you paid cash for the property, just like you said. But what if you don't pay cash, do you take that percentage and adjust for the projected mortgage to decide what to pay? Is there a reason you can't take into account the mortgage, it would seem that it would be more accurate? Thank you

@Ned Carey One more thing if you have time, or anyone else for that matter. When your using the biggerpockets calculator, why does it ask you for that Cap Rate before giving you the results, how does it change the results? Shouldn't it tell you the Cap Rate?

The higher it is, the better. It helps you compare apartment / commercial buildings.

@Daniel P Willis if you are using financing then you take the NOI and subtract the principal and interest. The amount you come up with is your net positive cash flow. Take that number and Divide it by the amount of cash you put in. This gives you the cash on cash return.

The reason you do not take the financing into account in calculating cap rate is that cap rate is a measure of the buildings financial performance. Imagine you are buying a business. You want to figure out how much that business is worth. Is the business worth more or less because you finance it? The business is worth what the business is worth. How you pay for it and your ultimate return is a different issue. The same is true with a building.

I don't use the BP calculator so I can't really comment on that.

@Rosston Smith made a comment the deserves to be expanded on. Higher cap rate is NOT necessarily better. 

For a given building, the amount of cash flow is a given (you might argue over how much exactly that cash flow is, but it is what it is.) So if you pay a lower price and therefore get a higher cap rate that is always good. Paying more for the same building means a lower cap rate and is always bad. 

However there is the market view of cap rate. If a building is selling for a high cap rate, it is because the market perceives it as a higher risk. People want low risk so they pay more for properties they perceive as low risk. This drives the prices up on those buildings and therefore the cap rate down.

In general low cap rate low risk. High cap rate means high risk. 

Another factor is that cap rate is a measure at a given point in time. It does not figure in the appreciation of a building which could be the most significant profit potential of a property.

A lot of misinformation being passed around on this topic thread. If only there were somebody who knew about CAP rates that could correct all this misinformation ...

@Ned Carey Thank you that makes a lot more sense, the Cap Rate is there to show me some insight on how much the building could be worth while COC return is how much profit i'll actually realize after financing the property. So Cash rate is just simply a tool to show value, and/or risk, not necessarily a representation of true net cash flow.

Thanks I greatly appreciate it, if i missed anything or got it wrong please tell me, otherwise thank you very much and have a great night.  

Just make sure you take multiple factors into account and not just one viewpoint of analysis like cap rate. 

@Daniel P Willis yes you have it right.

@Rosston Smith you had it right you were just looking at it from only one perspective.

@David Faulkner if you have something positive to say please say it. if I have stated something wrong please correct me. 

Originally posted by @Ned Carey:

@Daniel P Willis

@David Faulkner if you have something positive to say please say it. if I have stated something wrong please correct me. 

 I don't wish to get kicked off of BP by trying to correcting anyone.

@David Faulkner This webpage is all about sharing information and meeting other investors and like minded people, if you have information to share thats wonderful but just instigating people doesn't help. If you have anything to share with me i'm all ears. 

Originally posted by @Daniel P Willis :

@David Faulkner This webpage is all about sharing information and meeting other investors and like minded people, if you have information to share thats wonderful but just instigating people doesn't help. If you have anything to share with me i'm all ears. 

I agree that this is what the website SHOULD be about, it is too bad that it has strayed from that mission ... my advise is to be VERY careful about who you take advice from. Many here haven't a clue but like to pretend, many others with ulterior motives. You'll know when you understand when you start to be able to spot them ... good luck to you, wish I could help more ...

I would like to give my opinion on Cap Rate, if you don't mind.

As far as calculating the Cap Rate, it's already been done by @Ned Carey and you could and probably SHOULD read about the calculation to solidify it in your mind.

As @Ned Carey mentioned, there is a Market View of Cap Rate.

Because @Daniel P Willis is new to this Calculation, I would like to address it a little bit more and how to use this Market View.

When I am analyzing a potential property for investing, I calculate not only the Cap Rate on the target property, but as many other properties in the area that I can get the numbers for it to do the Cap Rate calculation.

If there are properties with HIGHER Cap Rates then the target property, you would need to try to figure out WHY. You have to think to yourself that the only reason you can get a lower Cap Rate than the comparable properties near by must be for one of two reasons:

1) The Purchase Price of your target property is too HIGH or

2) The Net Operating Income (NOI) is too low either because one or several expenses are too high or the rents are too low.

If you cannot get an overall understanding of the Neighborhood Cap Rate, then you cannot know if you are buying at a reasonable price or not. Or at least you do not know if something about the property that you are buying is adversely affected financially or not.

What could Adversely affect a property? For instance, much higher property taxes than the comps. 

However, you can also take advantage of this.

Following the same example, if you discover that the Cap Rates are in line with the Market, AND you believe you can dispute a high Property Tax to get it significantly lowered, you effectively had bought a bargain once you get the Property Tax situation corrected.

Another example, and probably the more important one, is that the comps for Cap Rate should match the neighborhood amenities and crime rates.

For similar properties and cap rates, you need to get paid much more for areas of higher crime and less amenities. This is actually incredibly important in places like NYC where you can buy an Investment property that you think is great at a reasonable Cap Rate but failed to see that it is right next to a high crime or undesirable area such as next to a homeless shelter. I've seen this many times as NYC has pockets of various City run small buildings here and there.

There is a lot to Cap Rates that Investors don't realize. I would say it's one of those hidden calculations that if used wisely, can improve your returns.

Investor Llew

@Llewelyn A. , you wrote: (hmmm, nope, nothing useful yet on this thread, surprisingly)...

The cap rate measures the capitalization return percentage over the history of the asset and not just one snap shot of time. Since it only applies to commercial using cap rate measurements on triplexes is virtually useless. These non commercial property values are only determained by comparitive sales for that reason. Good luck!

Originally posted by @Daniel P Willis :

So I have a single family home and a trailer that I rent out and my wife and I are looking at purchasing a triplex or quad. How does the Cap Rate work and at what time does that become relevant? I always try to learn as much as I can before making an investment and most of the forms that i've seen just say that cap Rate isn't something you have to worry about until its a commercial property. Why is this, why doesn't it matter and how does it work? 

     Any help is much appreciated, I would also like to know your experience with using Cap Rate and how it helped you in your investment, if its not to much trouble. 

   Thank you. 

 Why?

Let's say you have a triplex you bought for 100k and the seller says the cap rate is 2%. Bad deal right?....Hold on...one year later you sell it for 200k because that where the present comps are at. In this case, the capitalization rate was 100% but does that mean the cap rate is now 100% for the new owner? Naw, cap rates don't mean jack on non commercial properties and especially when using cap snap shots.

@Brent Coombs Let's look at an example. You are buying a property for $100k and it has an NOI = $10k (rents minus expenses excluding Debt Service). The Cap Rate is = NOI / Purchase Price (PP) = $10k / $100k = 10%. Let's say that's inline with the Market Cap Rate.

Now, you but the property and then you go to the County and fight and win a reduction of your Property Tax by $1k. Your NOI increases by the same amount of the Property Tax reduction now = $11k.

We now have to look at the valuation of the property you bought by calculating the Selling Price in relationship to the Market Cap Rate.

To Sell the Property at 10% Cap, PP = NOI / Cap Rate. So the new PP = $11k / 10% = $110k. Effectively, you increased the value of your property by $10k if you lowered your Property Tax by $1k.

I also wanted to expand on the Concept of Moving Cap Rates.

Depending on certain factors, the Cap Rate for Cities and Neighborhoods in Cities will move.

A typical example is when crime increases in a neighborhood.

If Crime increases over an extended period of time, years for example, investors will demand a lower price for the investment given the same NOI. Thus increasing the Cap Rate to compensate for the higher risk.

Similarly, if a neighborhood improves, the price of the property rises even if the NOI does not increase very much. This can be due to the perceived desirability from people just wanting to live in the neighborhood. This effect happens a lot during a period of Gentrification in Metropolitan areas.

What I tend to do is to buy in area where the Cap Rates have a distinct downward trend. Before of the above formula, PP=NOI / Cap Rate..... keeping the same numbers.... let's say that the Cap Rate for a neighborhood is currently at 10%. However, because Gentrification, we know from history of other neighborhoods that the Cap Rate is most likely to fall, and probably to 5% as other comparable neighborhoods are at 5%.

We can then do a Future calculation to determine the amount of Appreciation of the Investment.

For a property that you are buying at $100k with a Cap Rate at 10%, we know that IF the Market Cap Rate falls to 5% and NOI stays the same at $10k.... we will get the following Calculations.... Current calculations is PP = $10k/10% = $100k. When the Cap Rate falls to 5%.... the new calculations will be PP = $10k / 5% = $200k.

While all of this is fairly obvious, I think Investors need to do these calculations to get an intuitive feeling on how their Investment's future value may be affected.

You really want to invest in neighborhoods where the Cap Rate is MOVING DOWNWARD and NOT UPWARD.

If you have a good understanding of the surrounding neighborhoods and their cap rates and understand the history of those neighborhoods and their cap rates.... you can almost "feel" the Cap Rate as it moves along the wave.

Yes, it's probably way too much information! I realize that.... but after all these years as an investor who watches these things, I really get a clear sense of where to invest (or where to stay away from) and what neighborhood to target based on the wave of the Cap Rate movements.

Hopefully this helps in some way to the reader of this post!

Investor Llew

@Llewelyn A. , yep, that looks like a fair refresher course for anyone who needs it. I hope you understood that my only point to you was: if you buy a property at the normal market cap rate - why would the city agree that you have a good case to get your property taxes lowered? Cheers...

Originally posted by @David Faulkner :

A lot of misinformation being passed around on this topic thread. If only there were somebody who knew about CAP rates that could correct all this misinformation ...

 David, I believe Bob Bowling has left the building.  He would be the one to educate us, like him or not.

Since he is now 'account closed', I will try to add my $.02. The CAP rate is an effective measure of value and profitability in the commercial space only.

It will be for your s**ts and giggles to figure it out on your residential properties. NOI/PP does little for you in itself there, but can be a tool like a variation of tax assessed value and sold comps to try and find true FMV.

To understand if you are buying a good commercial value, you need to know the market cap for the type and area of a commercial asset.

PMs or commercial brokers in your area may know what the market cap is. Ask them. Unless you have a good grasp of what the CAP is in your market, you won't know if you are buying or selling at a good price. My market cap is 7.5%. It was 10 when I bought. At 6.5%, market value and re-build cost will be one and the same and in my area and I am selling.

Try to buy above your market cap and sell below.  Good discussion! 

To add a little to what @Steve Vaughan said, you won't be able determine market value on your residential properties using cap rates (that would be done via sales comps) but it could still be a useful number to you if you want to use it a little creatively.

If you had two rental homes and you wanted to compare them you could try to do that with cap rates. Let's assume they are owned free and clear so you're not having to calculate mortgage, similar to how NOI is calculated before debt service.

Property A

  • Sales Comp Value $200k
  • Cash Flow $6000 a year
  • Cap Rate 3%

Property B

  • Sales Comp Value $100k
  • Cash Flow $4000 a year
  • Cape Rate 4%

Now Property A has a lower cap rate than Property B, indicating it might be worth more than Property B. And sure enough it cash flows more and has a value of $100k more. But it could be that the cap rate is lower because the property value has appreciated in value faster than the rents has increased. If that's the case then you can try to determine if this is an up and coming area and the appreciation will continue or if it has reached it's peak. If it has peaked then perhaps the highest and best use of that property is to sell it and buy more houses like Property B.

I don't really know how valuable this method is but it could be an interesting data point. Like Steve said, sh*ts and giggles.

Yeah, BP sort of lost their only Ace in the Hole on all this cap crap. However and fortunately Llew, looks like he can also educate us accordingly. We are talking out of hundreds of thousands of members, maybe BP should take note this time. 

A capitalization rate is one financial measurement among many that can be used to quantify the performance of a property.  There is no good reason you can't use this for residential assets as well.  Residential assets are generally measured with comparables though because the bulk of the purchasers are not buying them as an investment.  Cap rates on residential assets are generally in the 3-5% range.  

Cap rates aren't really all that helpful in my experience.  They're generally misquoted because the liars and charlatans do a terrible job representing both income and expenses.  Income generally fails to account for economic vacancy properly and expenses often exclude many items.  Thus the cap rate is basically worthless.

Cap rates also fail to account for the time value of money, which is especially important when you're purchasing an asset for a long period of time.  

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