What is a cap rate and why are they important ?
Rental Property Investor · Member since 2020 · 46 posts · 29 votes
I hear the words “Cap Rate “ a lot. What is a cap rate and why re they important? Is it something added onto a loan interest rate or maybe equity in a property? What is a good cap rate?
Cap Rate, or Capitalization Rate, is the expected return on a commercial real estate asset if there were no debt on the property. For example, a property that was purchased for $1 million with no debt, produces Gross Revenue of $200,000 per year, the annual expenses are $100,000, leaving an annual Net Operating Income of $100,000 (Gross Revenue - Expenses). Divide the NOI, $100,000, by the purchase price, $1 million, and you get a Cap Rate of 10% (NOI / Purchase Price). Meaning you can expect a 10% return on your investment of $1 million.
Cap Rate can also be looked at as a function of risk. Investors expect a higher return for investments that are riskier in nature. If you purchase that same property above for $800,000 and it produces the same NOI, it's Cap Rate is now 12.5%. That might sound better, higher return is always better, right? Not necessarily. The purchase price might have come down because the market views the property as over priced.
Cap Rates are often effected by the interest rates. As interests fall, Cap Rates often fall as well, because investors are able to borrow money at low rates, because it theoretically lowers their risk. As interest rates rise, Cap Rates often rise as well.
The power of the Cap Rate can be seen when you start to discuss value-add opportunities.
For example:
Let's say I purchase that property for $1 million dollars at a 10% cap rate. Through a mixture of increased revenue and lowering expenses, I increase the NOI to $125,000 annually. Divide that new NOI by that 10% Cap Rate and that $1 million property is now worth $1.25 million. Not only did I increase the potential cash flow by $25,000 annually, I increased the value by $250,000. Now, if doing all of the above also made the asset seem less risky to other investors, they might think it's more of an 8 Cap now (8% Cap Rate). In that case, the property is now worth $1,562,000.
It cuts both ways though, let's say all of the above is true, but we have a sudden rise in interest rates that pushes the market Cap Rate to 12%. Now, that property, while we have increased the NOI by $25,000, is only worth $1,041,666.
There really is no way to determine what a "good" Cap Rate is because it depends on the investor's business plan, their goals, and their risk tolerance.
In self-storage, an A Class facility in a Primary Market (think multi-story, full climate controlled, in a city like Phoenix) might be considered a 5 cap. While a C Class facility in a Tertiary Market (think single-story, over 20 years old, gravel driveway, in smaller town), might be considered a 10 cap.
Again, it's largely a function of risk. Typically, the higher the Cap Rate, the higher the risk, but the higher the potential return.
Personally, I like to look for a Cap Rate that is at least 2% higher than the interest rate at which I am able to borrow, with a significant value-add opportunity.
Cap Rate, or Capitalization Rate, is the expected return on a commercial real estate asset if there were no debt on the property. For example, a property that was purchased for $1 million with no debt, produces Gross Revenue of $200,000 per year, the annual expenses are $100,000, leaving an annual Net Operating Income of $100,000 (Gross Revenue - Expenses). Divide the NOI, $100,000, by the purchase price, $1 million, and you get a Cap Rate of 10% (NOI / Purchase Price). Meaning you can expect a 10% return on your investment of $1 million.
Cap Rate can also be looked at as a function of risk. Investors expect a higher return for investments that are riskier in nature. If you purchase that same property above for $800,000 and it produces the same NOI, it's Cap Rate is now 12.5%. That might sound better, higher return is always better, right? Not necessarily. The purchase price might have come down because the market views the property as over priced.
Cap Rates are often effected by the interest rates. As interests fall, Cap Rates often fall as well, because investors are able to borrow money at low rates, because it theoretically lowers their risk. As interest rates rise, Cap Rates often rise as well.
The power of the Cap Rate can be seen when you start to discuss value-add opportunities.
For example:
Let's say I purchase that property for $1 million dollars at a 10% cap rate. Through a mixture of increased revenue and lowering expenses, I increase the NOI to $125,000 annually. Divide that new NOI by that 10% Cap Rate and that $1 million property is now worth $1.25 million. Not only did I increase the potential cash flow by $25,000 annually, I increased the value by $250,000. Now, if doing all of the above also made the asset seem less risky to other investors, they might think it's more of an 8 Cap now (8% Cap Rate). In that case, the property is now worth $1,562,000.
It cuts both ways though, let's say all of the above is true, but we have a sudden rise in interest rates that pushes the market Cap Rate to 12%. Now, that property, while we have increased the NOI by $25,000, is only worth $1,041,666.
There really is no way to determine what a "good" Cap Rate is because it depends on the investor's business plan, their goals, and their risk tolerance.
In self-storage, an A Class facility in a Primary Market (think multi-story, full climate controlled, in a city like Phoenix) might be considered a 5 cap. While a C Class facility in a Tertiary Market (think single-story, over 20 years old, gravel driveway, in smaller town), might be considered a 10 cap.
Again, it's largely a function of risk. Typically, the higher the Cap Rate, the higher the risk, but the higher the potential return.
Personally, I like to look for a Cap Rate that is at least 2% higher than the interest rate at which I am able to borrow, with a significant value-add opportunity.
"What is a cap rate and why re they important?"
CapRate = Net operating income / Sales price
Why are they important? Most people accept they are an accurate representation of value.
I kinda think they are BS:
1) They're reported. Depends on who gives them - Owners, brokers, appraisers, buyers. So reporting bias.
2) What numbers are they based on? Actuals or, god forbid, pro forma
3) They don't account for futures. If a diamond is at peak performance and low caprate is it worth more/less than something with upside at a higher CapRate?
4) They don't account for the cost of money which affects CFBT.
@Isacc Lightbourn " The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market."
If you are n residential, don't worry about it, if you're jumping into commercial, read a book about it!
A simple google search of "cap rate" would result in a variety of definitions. On the one hand cap rate is defined as some type of measure of return while on the other hand it is defined as a measure of value. These polar opposites of cap rate definitions can be illustrated below:
From Investopedia (https://www.investopedia.com/t...). This definition is also quoted by another poster.
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market.
From Wikipedia (https://en.wikipedia.org/wiki/...)
Capitalization rate (or "cap rate") is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.
I'm with the Wikipedia definition in that Capitalization Rate is a valuation measure. Cap rate is a rate at which a certain type of income (i.e. in this case NOI -> Why do we pick NOI? This deserves another post!) is capitalized into value. An easier way to look at this, cap rate is a rate that converts a dollar of NOI into x dollars of VALUE. That's all cap rate does! For a lack of better word, it is really a conversion rate! It converts NOI into VALUE (much the same way a money changer converts US Dollars to Mexican Pesos at the southern border). Wikipedia has several examples of the use of cap rate as a valuation measure.
I don't think cap rate was ever designed to measure performance. Many businesses use a variant of cap rate (the "income" approach valuation) to value the business (i.e. gas stations, consulting firms, etc). When it comes to measure of performance/return no one ever asks for the cap rate of a gas station or a consulting firm. They do however ask for some variation of profit margin, yield, etc. Incidentally, the formula of the metric Operating Yield on Cost is identical to cap rate (i.e. NOI/Cost).
IMO, the cap rate definition on Investopedia is wrong. It is unfortunate that when you google "cap rate" the Investopedia cap rate definition usually comes up high in the search result so people read it and think that cap rate is a measure of performance/return. Worse yet, they perpetuate this incorrect definition by referring other people to it.
Cheers... Immanuel.
I have an idea, how about every just type it in Google and then copy the first answer that pops up, haha.
@John Erlanger just curious why you say it is not an expected rate of return, assuming cash purchase? NOI is net operating income, so assuming you paid $100,000 cash for a property and got $10,000 NOI, that would be 10% return or 10% cap rate.
My take on CAP rate is that it can be useful for evaluating larger apartments or commercial real estate, but it has less value for single family homes or small multifamily. It is really just one of many different numbers you can use for quick evaluation. I think sometimes people get hung up on these "fast rules" like cap rate, 1% rule, 50% expense rule, etc. These are just meant to be high level evaluation tools to quickly gauge a property. You really need deep analysis of all expenses, income and financing terms to conclude the true return of any investment.
I have an idea, how about every just type it in Google and then copy the first answer that pops up, haha.
Yeah, but if it's Google, on top of the list will be a sponsored message from a Russian bot declaring Trump is fixing CapRates as a favor to Putin.
I'm with the Wikipedia definition in that Capitalization Rate is a valuation measure. Cap rate is a rate at which a certain type of income (i.e. in this case NOI -> Why do we pick NOI? This deserves another post!) is capitalized into value. An easier way to look at this, cap rate is a rate that converts a dollar of NOI into x dollars of VALUE. That's all cap rate does! For a lack of better word, it is really a conversion rate! It converts NOI into VALUE
Cheers... Immanuel.
Maybe people would understand it better if it was called a conversion rate! Then it would be referred to as a con rate which is mostly how it is used against novices. Ha Ha
Absolutely appropriate, especially on those Turnkey SFR's advertisements...
I have an idea, how about every just type it in Google and then copy the first answer that pops up, haha.
The good thing about Google is you can find everything on it. The bad thing about Google is ... you can find everything on it.
Cheers... Immanuel
Advice given here is spot on. Just another way to attempt to give depiction of value.
Yeah if someone just dismisses a deal because it has a low cap rate they are missing part of the picture.
One secret is if you can parse out valued where others miss, this will give you an edge.
There are so many other variables to factor in.
Like financing [commercial, residential, owner carry]- Interest rates, terms etc.
ie: Owner occupied 4 plex vs an investor owned - Same price - totally different metrics and outcome.
What is the future upside, can you increase revenue. Can you add sq footage [now can you convert or add an ADU] What is the lot size has a better function of value that might not represent future upside.
Can you create a higher and better use of the property. Is it in the path of progress. Can you invest and be in the path of progress.
Here are some other terms that is a good idea to familiarize with that will affect your CAP rate and your overall strategy.
NOI - Net Operating income
GRM - Gross Rent Multiplier
CASH on CASH - How much income to you make on cash invested
an expected rate of return, assuming cash purchase?
@Greg Dickerson
@Ivan Barratt
@Paul Moore
Joe, you realize that the cap rate will be the same no matter what the financing is? That is because it is not a return measurement. I see where you have come to this incorrect conclusion since there are BP people that proclaim this when they should know better.
Maybe this will help put this incorrect notion to bed,
@Brian Burke
I used the word cash multiple times to be super clear that cap rate gives you one year projected rate of return, without financing in the equation. Of course financing changes the equation. I was clear on that, so why throw it at me and claim that is the smoking gun that makes my comment wrong?
Cap rate uses NOI, which is net operating income. If you purchased a property with all cash, it is a fair expectation that your projected cash rate of return in year one would be around the cap rate. The math is pretty simple, so I don't see how this statement is incorrect.
Cap rate is a high level way to compare different investments without financing in the equation. Your actual return over time depends on many variables, one of which is financing.
I honestly never knew cap rate was an item to debate. Scour the internet and hundreds of people agree with my general comments.
@Neil Henderson Just want to commend you for an excellent, informative write up! Well said!
an expected rate of return, assuming cash purchase?
@Greg Dickerson
@Ivan Barratt
@Paul Moore
Joe, you realize that the cap rate will be the same no matter what the financing is? That is because it is not a return measurement. I see where you have come to this incorrect conclusion since there are BP people that proclaim this when they should know better.
Maybe this will help put this incorrect notion to bed,
@Brian Burke
I used the word cash multiple times to be super clear that cap rate gives you one year projected rate of return, without financing in the equation. Of course financing changes the equation. I was clear on that, so why throw it at me and claim that is the smoking gun that makes my comment wrong?
Cap rate uses NOI, which is net operating income. If you purchased a property with all cash, it is a fair expectation that your projected cash rate of return in year one would be around the cap rate. The math is pretty simple, so I don't see how this statement is incorrect.
Cap rate is a high level way to compare different investments without financing in the equation. Your actual return over time depends on many variables, one of which is financing.
I honestly never knew cap rate was an item to debate. Scour the internet and hundreds of people agree with my general comments.
You asked me about a cap rate and why I say it is not a return. There is no debate except from some people that don't understand what it is or they know but want to trick people. Not trying to throw you under the bus but to show you that cap rate is not what you think it is. Is that fair in answering your question?
You are just repeating your flawed thinking and have not addressed the examples I gave that clearly show that a cap rate does not measure return. I also linked a blog of @Brian Burke that also clearly shows that a cap rate is not a return. You are also clearly ignoring direct capitalization which is where cap rates come from.
Can you answer this question. If a seller is selling $100,000 NOI in Ohio for $1,000,000. And a seller is selling $100,000 NOI in CA for $2,000,000 that is a 10% cap rate and a 5% cap rate. Can you explain to the Ohio seller why he is getting half the price for twice the "return" than what the CA seller is getting? Assuming they both got cash and that the cap rate is a "return".
Yes if they both paid cash, they could expect their first year rate of return to be the cap rate. (Do you dispute that statement and if so show the math please.) Over time, I would expect the California property to have more appreciation in rents and appreciation in property value. When you sell the California property, the overall return may be higher. The longer you hold the property, the more likely that is true.
I never said buying something with a higher cap rate was a better investment. Many other factors are important such as financing, hold strategy, property condition, opportunities for unlocking value, expected appreciation, etc.
Of course saying a lower cap rate makes something a better investment is also oversimplification. Anyone can offer their property up for sale at whatever cap rate they desire. There is no rule that you need to sell or buy at market cap rate, but market cap rate does establish fair market value. There are also many strategies in real estate. Some people look for short term cash flow over longer term appreciation.
@Rob Massopust
I have not seen GRM used in a long time. You see it mentioned in some of the older real estate investing books from the ‘80s. I'm curious if anyone is currently using it to value SFH and small MF. What in your opinion is a "good" GRM?
I guess the 1% rule is a crude version of GRM. 1% rule ~ 83 GRM.
@Rob Massopust
I guess the 1% rule is a crude version of GRM. 1% rule ~ 83 GRM.
Think you mean 8.3 (=1.00/12%)
@Isacc Lightbourn Cap Rate = Most overrated metric in real estate
@Rob Massopust
I have not seen GRM used in a long time. You see it mentioned in some of the older real estate investing books from the ‘80s. I'm curious if anyone is currently using it to value SFH and small MF. What in your opinion is a "good" GRM?
I guess the 1% rule is a crude version of GRM. 1% rule ~ 83 GRM.
I like GRM to ballpark plexes. Its my favorite initial analysis metric.
When a seller calls me I can give them a quick multiple range of monthly rent I'd be a buyer at. I realize GRM is annual, but monthly is easier for sellers (and me) to compute quickly. Theyll often say hold on a sec and get their calculator out.
I'm also old school and read the 80s books. Maybe that's part of it. LOL. Perfectly fine to use old strategies when your youngest plex seller was 63.
As far as cap rates go, I like to know the market cap of my commercial assets and of select asset types Im interested in in my markets, but I don't use it a ton. When potentially large expenditures needed like capital improvements are excluded from NOI, the accuracy of listed cap rates of buildings for sale are always suspect. But I do figure true and pro forma if under contract to purchase.
@Joseph ODonovan
I haven't dealt with cap rate before but am now in the middle of my first commercial deal. Cap rate is one of the main things that lenders ask and I had to do some googling and asking around to figure that out (well somewhat ;-). If my offer is accepted, I actually am going to evaluate the property on the 1% and will be paying mostly cash with the balance being owner contract... So luckily i wont have to jump through all the lender hoops and cap rates around commercial properties.
1% rule is easy math for me... Just going to stick with that for now regardless of what i am buying.
Cap rate matters even for SFRs. For example, if current interest rate is 3.5%, I know that for a property in a decent city with cap rate above 5%, it may worth to invest, while it may not worth to invest (or too risky) for a property with just 3% cap rate. I also know that if my property's cap rate reduces from 10 to 3 and it is located not in a great city, it may not worth to hold and may be a good time to get rid of it and use the fund else where. Cap rate is still an important number to decide whether it is a positive leverage or negative leverage, and it is still one of the most important ratio for me to make my investment decision, even for SFRs.
Cap rate matters even for SFRs. For example, if current interest rate is 3.5%, I know that for a property in a decent city with cap rate above 5%, it may worth to invest, while it may not worth to invest (or too risky) for a property with just 3% cap rate. I also know that if my property's cap rate reduces from 10 to 3 and it is located not in a great city, it may not worth to hold and may be a good time to get rid of it and use the fund else where. Cap rate is still an important number to decide whether it is a positive leverage or negative leverage, and it is still one of the most important ratio for me to make my investment decision, even for SFRs.
Nah, direct capitalization formula is V=i/r. You may be able to determine NOI on a SFR but where would you get the r? Without the r you are wasting your time.
Are you saying we must know cap rate first before we buy any single family? I doubt that.
Congratulations on working towards your college degree. And hopefully starting to house hack after you graduate. Although I did learn technical thought processes going through college (Accounting), the main thing I learned of value was there are different approaches and perceptions of the same concept. Sometimes Perception or Reality don't matter, your just wanting to a make a good deal.
If you do get into real estate you will get into Cap rates and also Cash on Cash metrics. Keep this in mind, I the seller am probably telling you the buyer the metric. You have to both trust both of us have the same concept on how the metric is derived and also if we used the same info. Basically don't trust me as the seller, you need to validate.
I don't use either metric, but then again I mainly do developing. I worry about collateralization and cash flow. How much do I have to put down up front for a loan. I shoot for a loan with a 20 to 25 year amortization. An operation with an 8 to 12 year payback. Thus I am cash flow positive and if trouble hits, I have some slack; or I pay the loan off early. Remember you make your money up front in your decision, its hard to make it later.
Back to Cap rates. Use them as a guide. Determine your metric. Just because a house falls outside of your metric you still might pursue it. Example:
Exact same neighborhood, exact same price, exact same CAP rate.
House 1: At the end of a T intersection, on normal lot. 2 BR, 1 bath
House 2: Corner lot, 2 BR, 1 Bath
Even though the cap rates are the same, you pick house two, because it has greater resale value, and might have the expansion potential with land to a 3 BR, 2 bath.
Now someone will say, but they should not have the same Cap rate. Hey the two Realtors calculated it. Whether they did it correctly or not, you have to see past that.
Luckily you will work through this. Do about 10 business calcs on you House Hack, before you ever get involved. Have someone talk them through with you. Join a local group. The next 10 years of your career will be the best time ever, even though your hanging by a thread sometimes. Step to the side every once in a while and pat your back for your successes and for your losses, say ouch, but great learning event. Enjoy the ride.
I do Self Storage, so I stay away from houses. In 10 years, call me and say hey, the 85 year old guy with the 35 rentals, does he want to sale? Hopefully he is still alive. By then you should be able to take on an acquisition like that. That is how much you will grow in 10 years.
Start small and make your Big Mistakes Early.
Folks this thread is started by Mr Lightbourn for his edification. Not for our personal truisms.
Mr Erlanger please summarize to Mr Lightbourn at his stage of the game how to use Cap rate, from your perspective. I believe your view is to not use them as all for House Hacking. Just tell him that. He either can delve into the calculation further, or he can take your advice and move on to the next aspect of valuation. Which you can guide him down.
He is still in college and yet to graduate. When he gets out on the Real estate side, he will try to do House Hacking.
Mr Lightbourn, my summary is this from above. There are normal metrics used in any business field. Use them as a base, but look beyond those at the value of the property. Me personally I don't use Cap rate, even though it is used often in the Self Storage field. I also don't use Cash over Cash. I have already stated the metrics by which we run our operations.
Good luck in your endeavors.
@Neil Henderson
Wow, thank you so much for taking the time out of your day to give me this wonderful definition and examples! The examples helped me immensely !
I feel like an expert on it now!
Thank you,
Isacc L.
I did not expect so many replies! I read every single on of them and all the different definitions and debates really gave me the best perspective on it. Thank you all so much! I love gaining new knowledge! I can now discuss this topic with confidence thanks to all of you!
@John Erlanger I've read comments here. I am new but I've done a few apartment deals and business acquisitions using what you would consider "false" math and numbers so I'm curious to understand this better:
Ohio $1,000,000 @ $100,000 NOI = 10% cap rate
CA $2,000,000 @ $100,000 NOI = 5% cap rate
From my understanding yes I would say that the seller in Ohio is in fact getting about half of what the CA owner is getting and that is for several reasons regarding market, trends, appreciation, etc. With businesses the NOI or multiplier and value can be different in different areas and industries as well. The "return" is of course dependent on many things including how well run the property and know your stuff.
But the cap rate (assuming it is honestly calculated) does give you a rough idea of that, am I missing something major? If so I can give a few examples because we do value adds to commercial properties and apartments and businesses regularly and everybody operates and uses/profits/refinances based on the cap rate. It isn't everything but in my experience most lenders and money people treat it very seriously.
Thanks is advance explaining.