Cap Rate for Residential and Commercial Investing

Denver, Colorado
General Real Estate Investing
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Cap Rate for Residential and Commercial Investing

Brady MullenPro Member
Denver, CO · Member since 2021 · 61 posts · 100 votes

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!

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  • Sam YinPro Member
    Los Angeles, CA · Member since 2021 · 584 posts · 738 votes
    3y
    Quote from @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!


    There are a few things I disagree with, and I know that there will be others who may have differing opinions.

    Although the foundation of your formula is basically correct, your interpretation is a bit incomplete. The CAP rate is also referred to as how desirable an investment is. Essentially, the lower the CAP rate, the more desirable the investment is in that local area. That is if it is sold at those numbers.

    Speaking from a commercial REI perspective, it is used far differently compared to residential use as you have done. Without taking other metrics into context, like GRM, ROI, IRR, etc., the CAP rate is the generally acceptable/preferred metric to compare similar assets in a given area. In essence, what an investor is willing to pay for a property based on its returns. In a desirable area, like A and B+, the CAP rate is lower. This is where investors are willing to accept lower returns in exchange for more stability, growth, less risk and lower turnover. The opposite goes for C and D areas.

    HOWEVER, when there is an upside in rents or hidden value that an investor can identify, the CAP can be skewed and is no longer an accurate gauge for value. This would be similar in the residential space. Because the number of doors is greater in the commercial arena, the gap between those values is wider. Oftentimes, when these factors are in play, you should not rely on CAP alone and should then begin to compare those other metrics like GRM and IRR.


    Finally, the last, and probably most important element of CAP, if you have not deduced it from the above explanation... the CAP rate calculated by the properties you are analyzing needs to be compared to the average CAP rate of similar assets in the area that have recently traded. That's the key! Your property CAP rate can be awesomely high, low, or whatever, but if the area's accepted CAP rate is way different, then your valuation will not hold and you will not get correct financing on that asset. This all goes out the window if you buy it in cash. But if you do, just know that your outlying CAP rate asset will be hard to trade because it is too far off from the norms of that local area. 

    This is where you need to be wise, not only to the OM, but also to the area you chose to invest. 

    For example, if I were to try and buy in Beverly Hills, I would need to accept 2% CAP rates or lower because that is the norm of the area. If a product in the area is offered at 4% or higher, there is something suspicious and likely false about it. Conversely, if I were to invest in the other side of town, say San Bernardino, then I expect roughly 6% CAP rates. If the OM is below 5% CAPs, why would I bother when the local norm is 6% or higher? Just as I would be attracted to 7% in that area but would be leery if it is offered at 9%. These things happen all the time and are misunderstood by many. They can cause a new investor to jump into a bad deal that penciled with solid CAP rates.

    The higher the area CAP is, the greater the deviations you can accept. Thus an area that is normally 2% CAPs can deviate by about 1% safely. An area with normally 7% CAPs can deviate safely by 2% or maybe even 3%, depending on recent trends. That may take a longer explanation, but you get the jist.

    Heck, I may be misunderstanding now even as I type. In any case, CAP rates are a good metric, but should not be the only metric or the dominant metric. It can be a very confusing metric.

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  • JD MartinBusiness Member
    Moderator
    Rock Star Extraordinaire · Northeast, TN · Member since 2015 · 10k+ posts · 17k+ votes
    3y

    If you are paying cash, then the only point in either case is just knowing what kind of return you are generating and how sellable your property is going forward. 

    If you are getting a note, then cap rate is irrelevant in residential markets because the note basis is always going to be based on the value of the property, regardless of how much rent it generates. You may be able to use potential rent to change some of your parameters, like DTI, but the bank is only going to loan you money based on what the property itself is worth. With commercial property, you are going to get a loan based on the income production value, so cap rate is highly relevant.

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