Cap Rate for Residential and Commercial Investing

[Brady Mullen]

I recently posted "Cap Rate Is Not Your Return" and had some really interesting conversations from it.  One I wanted to bring up as a separate post is how cap rate is used in commercial real estate investing verses residential (1-4 residential units per property).

I had many commercial investors say that cap rate is irrelevant in residential investing, and I want to suggest a different approach.

Before we go further, if you're unfamiliar with cap rate, the formula is Cap Rate = Net Operating Expenses / Property Value  OR  Net Operating Expenses / Cap Rate = Property Value.

First of all, cap rate in commercial investing is a variable that describes a market.  For example, class B commercial buildings in a certain part of Wichita, KS may have a 6.5% cap rate (I have no idea if this is true), which means you can find the annual Net Operating Income (revenue minus operating expenses), divide by 6.5% and come up with the value of the building.

Cap rate, in this context, is used to determine the value of a commercial building.

I am not a very experienced commercial investor, so if you are, and you are reading this, please correct me if I'm missing something.

Conversely, residential values are not based on cap rate.  They are based on comparable properties that have recently sold.  However, this does not mean that cap rate isn't helpful for residential investors.

Cap rate in this context can help an investor compare two different properties that have different profiles and determine which one pays more income relative to the value of the property.

Let's compare two properties to illustrate what I mean:

1) This property is available for $329,000, rents for $2,100/mo, has annual taxes of $1,300, annual insurance of $984, an HOA of $35/mo, and is in decent shape, but you want to assume it will take roughly $2,500/yr in maintenance and capital expenses.

2) This property is available for $475,000, rents for $2,900/mo, has annual taxes of $1,630, annual insurance of $1,216, an HOA of $50/mo, and you're assuming roughly $3,100/yr in maintenance and capital expenses.

It's tough to compare these quickly without calculating a cap rate, which shows which one creates more income relative to the cost of the property.

Property 1 Analysis: NOI = $19,996 (annual rents - annual operating expenses). Therefore, the cap rate (NOI/Property Value) is $19,996/$329,000 = 6.08%.

Property 2 Analysis: NOI = $28,254. Therefore, the cap rate (NOI/Property Value) is $28,254/$475,000 = 5.95%.

This helps see that property 1 (cap rate of 6.08%) creates more income relative to its value than property 2 (cap rate of 5.95%).

This is just a quick comparison, so I'm glossing over things like projecting some vacancy and some other details, but I hope it gets the point across.

Again, this is different than how cap rate is used for commercial analysis, but it's not unhelpful.

Lastly, I'll mention that cap rate is not everything.  Property 2 might still be the better buy based on location or other factors.  Cap rate is just another metric that is helpful in underwriting an investment decision.

Happy investing!