Questions about cap rate

[Logan Swanson]

I recently came into some extra money and want to invest in a mobile home park. Everything I see lists cap rates. What is a cap rate and why is it useful? Any information is appreciated.

[Jack Martin]

@Logan Swanson to keep it really general, cap rate is simply an illustration of the expected "rate of return" that investors are currently expecting to receive if they paid cash for a property.  In other words, investors are asking the question, "What return would I have to make on my capital if I were to buy this property for cash?" 

You will find there is always a current market cap rate for each specific type of property due to the recent sale of similar properties. When the market is strong cap rates get lower, and when the market corrects (like it did in 2007-2010) cap rates get higher.  Also, nicer properties and neighborhoods will always have a lower cap rate than lessor quality properties and neighborhoods. The more desirable a property is, the lower the cap rate will be.  (this is why a run down property in a tough neighborhood will have a higher cap rate) 

As already touched on above, cap rate can be misinterpreted, misrepresented, and deceiving, so learning about how it is used correctly (and incorrectly) is extremely important. To zoom out and make it really simple, investors use the cap rate as a divider of the net operating income (NOI) a property produces, in order to determine value. As an example, if a property creates $60,000 of NOI, and the true market cap rate for that property is 6%, then the value of the property would be calculated by the NOI (60,000) divided by .06, giving you a property value of $1,000,000.

There are many way sellers and brokers can manipulate cap rate, so it is important to understand how to value a property yourself and not rely completely what they are demonstrating. However, it is pretty easy to see if a seller or broker is being candid if you determine they are being honest about the NOI and the cap rate.

Continuing to use the example above, let's say the NOI on the property is $70,000 instead of $60,000. Using the same cap rate of 6%, the value of the property would be 70,000 divided by .06, giving you a property value of $1,166,667. So just by demonstrating the NOI is 10k higher, the value of the property went up $166,667. You will find this trick to be common where sellers and brokers misrepresent the real expenses that will be present on a property. In a mobile home park, when you see the expense ratio below 40%, be cautious that this kind of NOI manipulation could be taking place.

Continuing to use the example above, let's say the seller or broker is being candid about the NOI of $60,000, but they are using a cap rate of 5%. Then the value of the property would be 60,000 divided by .05, giving you a property value of $1,200,00. So just by suggesting the cap rate is 1% lower, the value of the property went up $200,000. You will find this to be common where sellers and brokers use a nicer property in a nicer neighborhood as a comparable (than the one they are selling).

All the best!
Jack