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Updated over 10 years ago on . Most recent reply
Cap Rate Question
How to properly figure out cap rate on an owner finance deal? All my houses are owner finance. It's pretty simple to figure out so I thought....
My first property I bought, I figured it like this:
purchase price: $51,000
rehab: none
taxes: 1215 annually
ins: paid by owner finance buyer
total revenue per year: $9672
So total revenue after taxes is $8457.
8452/51000 = 16.6%. Seems simple.
But then someone was asking me about other expenses. I don't have any....but, what about if the property ever goes vacant? Say in 4 years, she defaults? Then I have to spend 500-1000 dollars to foreclose, and it may sit empty for a month or two until I get a new buyer.
Also, it DID take me two months to find a buyer. So it was vacant for that period.
I don't know how to figure those into it. Vacancy rate is part of the rental equation but I wasn't sure on these deals I do. Thanks for any feedback.
Most Popular Reply
As others have indicated, what you have here isn't a cap rate, but instead a return or yield. The buyer (assuming a landlord buyer) would have a cap rate on the purchase, and that cap rate would be based on the purchase price and the NOI.
As for your return, while it may seem as simple as getting an $8452 return on a $51K investment, it's certainly not. For a couple reasons...
1. First, that $51,000 is gone. It's not like if you put that $51,000 into savings account, got interest on it for a year and then could withdraw the $51,000. In this case, you get "interest" on the $51,000 (not really interest, but a return), but you can never, ever "withdraw" the $51,000. It's no longer principle that you own. You've sold that $51,000 in equity with the house, and are in essence getting an annuity from it.
Think of it this way -- you say that your $8452/$51,000 gain is a 16.6% ROI your first year. But, if you don't get another penny after year one, you've just lost about $42,500! Now, I assume you're getting more money after year one, but you haven't told us how much or for how long.
Question: If I offer for you to give me $51,000, and in return I agree to give you $8452 after year one (with no other information about subsequent years), would you think it's a good deal? What if I reminded you that the $8452 you were receiving was a 16.6% return on your money?!?!?
I imagine you'd yell at me, "I don't have enough information to determine if it's a good deal or not, regardless of the 16.6% return the first year!" Well, that's the same amount of information you've given us and are trying to convince us that it's a good deal...even though the information we have is the year one return. Again, if that's the only return you get, you just lost $42,500 on this deal!
2. When you factor in the "time value of money," that $8452 you generate next month or next year is worth less than if you had that $8452 in your pocket today. And the further out you're getting the money, the less it's worth. So, if you're getting $8452 every year for 10 years, that's not really the same as getting $84,520. The $8452 you got this year could be invested and -- by definition -- is worth more than the $8452 you'll get in year ten.
The true value of that income stream will depend on the initial cash investment, the specific stream of income you get from the investment and the discount rate (essentially your cost of money or opportunity cost).
To put things in more concrete terms, check out this post I wrote a couple months ago about calculating the net present value (NPV) of a seller finance deal:
http://www.biggerpockets.com/forums/48/topics/1649...
Probably worth checking this out as well, since it relates (Internal Rate of Return (IRR) is the flip side of the NPV coin):