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.
I couldn't read all these comments... Simply put cap rates are commonly used for properties larger than 4 units.
it is based on the assumption you paid cash for the property. NO LOAN. For example:
purchase price: 1,000,000
profit after all expenses: 100,000
cap rate =10%
it can be used as a tool for you to get an estimate of a larger multifamily value. Just do it backwards,
ask a broker for the market cap rate in the area of the property
find out how much they claim is their profit.
reverse the equation and you will have the estimated price of the property.
@Isacc Lightbourn plenty of members have already posted responses, so all I'll add is that a cap rate is a "moment in time" valuation that is only as good as the data used to plug into the calculation. Often I see investors use cap rate as the metric by which they pair one investment over another, or assign a future cap rate to a future disposition of an asset. This is fine for general planning purposes, but often varies greatly from reality.
All of the above factor into what the actual NOI is of an investment at one moment in time, and everything beyond that one moment is theoretical and proforma.
NOI is not profit. It is net operating income. It is not guaranteed. You have to collect it. Out of NOI you have to pay mortgage, capex and costs to collect. NOI dollars are not equal. It is the cap rate that values them. In a 10% cap rate market investors think they are only worth $10. In a 5% cap rate market they think they are worth $20. V=i/r See cap rates exactly measure what investors are paying for a dollar of NOI. They do not measure a return that the investor is getting!
@John Erlanger Thank you and I think I see what you mean. That there are other expenses to consider other than just the cap rate to determine how much you would make. But in your example:
CA building has X square footage.
Ohio building needs 4x to match the NOI.
Okay, but since the cap rate is a measure of the percentage of the money invested that you could reasonable expect to make back in the first year doesn't that take into consideration the differences you mention?
To put simply: from what I know the cap rate is the return you would get if you paid cash for the property, so 10%, 15%, etc. means if you paid X in cash you could get back 10%, 15%, etc. per year and it would take 10 years or whatever to get your money back.
That is the basic idea at least in my mind, of course there are many factors in what you would ultimately take home but as a general rule would you agree with that definition? I'm asking in part because I've never heard of the distinctions you are making. Thanks! = )
@Isacc Lightbourn it is gross income, 1k per month 12k per year cap, But nobody cares about gross , its all about net. Rent 12k per year, less, taxes , ins, PM V/M about 10% , then you have NET cap,. Make sure you are getting at least the 1.5 -2% cap, Meaning PP 65k, rent 1k, well the rent is just under 2% gross,
All the best
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.
Erlanger response:
Well it is good that you do not use cap rates since you clearly do not understand them. So why are you instructing the OP to use them to value SFR's? That is the blind leading the blind.
Mr Erlanger, you need to read and understand people and text. Stop trying to be the technical authority, without understanding the question and situation.
You did not take my hint about being useful. This thread is not yours. The individual who is just starting out in Real Estate, asked a basic question about Cap rates and his area of interest is House Hacking, when he finishes College.
You've heard the concept of KISS before during your career. If not, let me know if I need to explain it to you, if you can't follow your own snide comment about the blind leading the blind.
I am telling him not to use Cap Rate for his pursuits. If he has to use it at a filter level, but when looking at the individual assets look at their value. He needs to know, no more about the nuances of Cap rate at this time, unless he wishes to delve in. I did use SFH in my explanation, since his interest is in that field. My comparison was at his area of interest, versus pulling in Shopping Malls and Apartment complexes for discussion.
Might I recommend you start your own topic on Cap Rates, to be useful to folks. I will give you the following advice so you don't go down the rabbit hole.
Split the topic up as follows:
a. Definition and examples of actual Cap rate calculations at a macro level. Show variations of items included and not included at a more granular level.
b. Define areas of investment where Cap Rate is useful, and where not, and why on both counts.
c. Explain why specific cap rates are beneficial or not beneficial from the perspective of the party. Investor, seller, realtor, etc. Example: 5% versus 8%.
d. Give examples of your own deals, how you have worked your way through the usefulness of the seller or realtors cap rate presented to you.
If you wish, send it to me for review, to make sure you haven't digressed.
Here's one of the best and easiest explanations of Cap Rate that I've found:
The cap rate measures your cash flow, relative to property value. Cap rate equals annual net operating income divided by the acquisition price.
Let’s say that you’re looking at an investment property that you could rent for $1,200 per month. First, let’s calculate the potential rent at full occupancy. This is the best-case-scenario.
Then we subtract a reasonable vacancy estimate. This gives us our “Effective Gross Rent.”
Next, we’ll add any other income sources that are associated with the property, such as pet fees or coin-operated laundry income. Let’s say that this comes to $500 per year. We’ll add this to the Effective Gross Rent, and we now have a new yardstick: the Gross Operating Income.
Next, we’ll subtract the operating overhead. These are the expenses associated with running the property, such as utilities, water, trash, repairs, management and maintenance. It doesn’t include the principal and interest on your mortgage (I’ll explain why below), but it does include insurance and property taxes.
For the sake of example, let’s say these expenses come to $6,180 per year.
Congrats, you know your net operating income, also known as "NOI."
To find the cap rate, divide $8,000 (your NOI) by the total acquisition price of the house. Let's assume your house cost $200,000, including closing costs and upfront repairs.
$8,000 / $200,000 = 0.04
Multiply your answer by 100 to convert it into a percentage. The $8,000 in cash flow you’re receiving translates to a 4 percent cash flow return on your property value. **You want a Cap rate of at least 5%**
REMEMBER: Net Operating Income is the money leftover after you’ve paid operating overhead. Don’t confuse this with your cash flow (after paying the mortgage); these are not the same.
Hope this helps.
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
This is so true re cap rates. I see you're in Orange County. In LA and OC, cap rates are low. However, there are a good number of properties where you could improve cap rate (increase rents, reduce expenses), and thus increase the value of the property considerably. I've seen smart folks buy stuff in the high 4 cap range, increase NOI by 30% in a cost effective way over several years, and sell or cash out refi (at that market cap rate they purchased at, sometimes even a bit lower).
I want to find the Cap Rate for a specific area. I am looking in the Belleville IL area but I am having trouble finding the cap rates. I checked with a few property management companies and they weren't able to give me a clear answer as to what the cap rates were in the area. Any suggestion on how to find out this information?
@Samuel Gates I'm not sure why your looking for cap rates for an area as any analytics you find for a city are going to be based on HUD reporting and not an accurate reflection of what the market is doing. However, just go to HUD website and you can find the data. If your investing, the cap rate your looking for is what you feel comfortable with based on your strategy.
@John Erlanger GRM's have many uses other than your statement and are used in large multi families and large syndication deals. They are just one of many metrics investors use to filter listings and leads. I actually would never use GRM for any metric in a small deal, doesn't make sense.
@Todd Pultz thanks for the advice, I will go to Hud reporting. I was trying to use the Cap Rate in the area to valuate this 8 unit. I wanted to make sure that I was not to overpaying for the property.
@John Erlanger your making some good points on this thread although I think your taking a fairly stubborn and close minded approach to do so. You have a good handle on cap rates, but your opinion is just that, your opinion. While you may not use cap rates in a certain fashion, that doesn’t mean others don’t.
You stated you can not value SFR's using a cap rate. That's just not true. Most commonly, we would look at sales comp approach, but if your selling a portfolio of SFR's you can certainly market that portfolio based on a cap rate rather than a sales comp approach.
You made the mention several times about people overpaying for a property. How do you know they are overpaying? A property is worth what someone is willing to pay in a moment in time. Overpaying takes many different forms and just because you wouldn’t pay the amount, does not mean someone else overpayed. An example of this might be someone with 1031 funds set to expire and they have to pay retail price for a property. In your mind they may have over paid, but in their eyes, they saved a whole heck of a lot of taxes.
This thread had downplayed the importance of understanding cap rates for the OP, but cap rates are huge part of this business and for us larger multi-family guys, an extremely important metric in negotiation and causing a seller to justify their price. Additionally, for the large number of people that are infatuated with the BRRR, rest assured, cap rates will come into play if your brrring a multifamily deal when you get to the refinance part.
Cap rates are the expected rate of return on a commercial investment property. Of course that expected rate of return is affected by mortgage, capital improvements etc which after subtracted, take you to your true cash flow. This is what your trying to say, but it’s getting washed out because your trying to make it too difficult.
Investing is common sense and the numbers do not have to be difficult to understand with crazy chalkboard formulas.
@Samuel Gates the cap rate will not tell you if your overpaying for it, only you can do that. When you evaluate a property, your not overpaying if the numbers work for your goals.
A better metric is to look at your debt service coverage ratio as this number doesn’t do a lot of lying. It’s also what your lenders are going to use.
@John Erlanger I just said in other post you were making cap rate too difficult for the OP, but now your over simplifying. Let me explain why your sales comp approach may not work.
House A gets $1000 in rent, but landlord pays gas, water, trash, electric for tenants so now he really only gets $700 in rent
House B gets $1000 in rent, but landlord pays none of these
Which is more valuable to an investor? In your theory, they are both worth the same, but if you would have looked at the cap rate, you could have saw a red flag that would have caused you to investigate further during your due diligence.
These two examples are not worth the same to investors
Appraisers also look at these factors when appraising income properties and they adjust accordingly.
@John Erlanger since your profile has nothing on it, I’m not sure your experience level, but you are obviously on a mission to insult everyone on the thread that disagrees with you including some of us with a large amount of experience.
Now on the surface, it appears our sales comp and cap rate would be the same in our sale examples. My example however pointed to the expenses out of those rents while you simply stated a gross rent amount in an attempt to over simplifying. Maybe you were referring to same method, however you are forgetting that OPS posting on here have very little idea of investing and by oversimplifying your doing them a disservice. Cmon man, you gotta be smarter than this.
Now, you are attempting to argue semantics with what cap is. I gave you a compliment and said you made some good points, but here is your stubbornness........
I said cap rate was expected rate of return, not the actual return. Whether you use it in a pro forma or actual situation it's the expected rate of return and not the actual rate of return. Yes, it is what your buying the NOI for, which is your expected rate of return similarly. We are saying the same thing, just in different manners. And that's ok! Cash on cash return is what we should have educated him on, but you chose to insult everyone including the poor guy that is new and and asked a simple question. Maybe your the smartest guru out there, I just could not find anything on your experience, so I apologize.
@John Erlanger your a funny guy. Remember, we’re not your enemies. Send me a DM and I’ll give you some resources to look up my experience and investment strategies. Maybe, I’ll let you join a few of the conversations we have on networking and building healthy relationships in investing. Nobody is whining big guy, just calling you out for your horrible tact.
However, your questions I will engage briefly.
GRM's do not get used by myself or others I know to purchase real estate. However, it is one small component that we use to filter or point us in a direction for due diligence. The lower GRM the better you and I would agree correct? That means we are paying our property down faster as our acquisition price is lower correct? So if GRM is low and looks good, but then we see a low cap rate, that would indicate the NOI may not be great and might indicate the property is being operated inefficiently or there may be some significant issues with the property that need to be explored. It's used as a guide initially, but a very small piece to equation.
Now, can I calculate house A and house B NOI? Sure, but not in your example because I have no idea what your expenses are. On your 1000 gross rent house let's assume you have 200 expenses and NOI is 800 monthly, so 9600 annually making your cap rate 9.6
Your 950 rent house has 450expenses monthly because you pay all utilities, so 6k NOI annual making your cap rate 6. However, you gave none of that information and only talked about gross rent of 1000 and 950 making it simple 10 cap and 9.5 cap, but that's not NOI and you can't put a value to those two houses unless your selling as a SF based on sales comps. If your selling as an income producing property whether by itself or in a portfolio, cap rate based on a NOI is important. Most smaller portfolios have to stand alone regardless of their portfolio when appraised unless your doing a portfolio loan that does not require that.
However, along with hundreds of doors, hundreds of wholesale deals, dozens and dozens of flips, new home developments.......I am also a realtor and will tell you this. I can show you countless examples of taking a SFH and selling well above sales comps by justifying the price based on the NOI of the actual property through an actual income approach. I can also show you properties I've had to sell for under sales comps because the NOI did not support the sales price due to it being sold as a income property.
I give a pretty detailed rundown here if you're interested: https://www.biggerpockets.com/...
@Neil Henderson barnone the greatest context of cap rate that I've ever read. I try explaining to so many novice investors that there are so many external factors that determine what's considered a "good" cap rate. Personally I've never thought about how greatly interests rates impact the CAP. Also, the example you used also truly spoke to if the investor is in acquisition or disposition mode. $1.5m sounds a lot better than 1.0m if I'm selling.
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?
I didn't read the whole thread. So, this may duplicate someone else's answer ...
Cap Rate - short for Capitalization Rate - among other things tells how quickly a commercial investment will pay for - Capitalize - itself. The lower the number the faster the payback. Also, the higher the number the less cash it produces before debt service.
Just another perspective ...
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?
I didn't read the whole thread. So, this may duplicate someone else's answer ...
Cap Rate - short for Capitalization Rate - among other things tells how quickly a commercial investment will pay for - Capitalize - itself. The lower the number the faster the payback. Also, the higher the number the less cash it produces before debt service.
Just another perspective ...
Although I don't see cap rate as a payback metric, this seems backwards to me.
Lower cap rate takes slower NOT faster to payback, doesn't it? Shouldn't higher cap rate produce more cash NOT less to service debt?
Cheers... Immanuel
@Isacc Lightbourn Short and simple Cap Rate is the following:
Definition: Capitalization rate, commonly known as cap rate, is a rate that helps in evaluating a real estate investment. Cap rate = Net operating income / Current market value (Sales price) of the asset. Description: shows the potential rate of return on the real estate investment.
Without even knowing your background, your about to hear the same thing you have heard your entire career. "It's not about you." When your responding to someone else's thread answer their question and support them in their growth. This is not about your personal ego or need to demean people. If you have done any deals, look back at the times you have corrected realtors, demeaned the owners of the property, or challenged an Appraiser just to prove your correct. That's not a win, winning is getting the deal done. This is not about your ego.
a. Again, I will be more than happy to review your responses or threads on a separate PM before you post them, so they are more beneficial. You obviously don't have a "tact" filter.
b. Taking your knowledge and/or experience with Cap Rate, recommend you start your own post for the benefit of all the users. I have already outlined above the approach you should use to fully cover the subject. Your above one offs, will be better served as a true effort on your part, if you pull them together in a formatted approach.
c. All of your comments I have read, are from a purely technical standpoint. Bring your real world experience into the discussion. As the majority of the successful and experienced people on this forum will tell you, 1 + 1 does not equal 2. It better equal 3 or more, otherwise we wouldn't be in the game. If you don't understand that concept then you haven't been doing real world deals. I invest $1.7mm over the course of 2 years and now it is worth $2.7mm, that's a real world application. And it is not about "me" being correct during that process, its about "me" fighting through every reason or instance to not be successful.
Go back to @Isacc Lightbourn and revisit both his questions and his background. And see how you can help him move forward in his RE future. If he needs guidance in "valuation" in terms of his avenue, House Hacking, give him your expertise; if you don't believe Cap Rates is applicable.
@Isacc Lightbourn
Cap rate is a great tool when used together with other metrics.
While cap rate does tell you the return on an investment it does not account for risk
Deal 1
A nnn deal with chase bank as the tenant on a 15 year lease.
Deal 2
A 20k sqf flex space with 10 mom and pop tenants with varying leases, anywhere from month to month to a year.
Both of these deals are producing a NOI of 100k and they are both selling for 1 million
By just using the cap rate there would be no reason that one deal is better then the other.
When factoring in the risks obviously the chase bank is by far the better deal and the two are not even comparable.
Throw in another factor. The chase bank is in middle of nowhere and the 20k sqf deal is in the center of Manhattan. Now things change. Which is the better deal now? It’s all about the risk adjusted return.