Cap Rate Question

17 Replies

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.

@Account Closed - CAP rates have absolutely nothing to do with financing. So whether the deal is owner financed, cash or some other terms the CAP rate is the same.

Now, if you ask 20 different people to compute the CAP rate you'll probably get 20 different answers. CAP rates are often based off of past performance, which is a pretty foolish approach to valuing a building. Not only do you have to assume future operations will remain the same (in this case, never having a vacancy expense) but you also have to rely on the seller/owner to provide every expense they incurred.

When I compute a CAP rate, it is building specific and all income and expenses are best estimates. Just because you didn't have any vacancy does not mean you can leave it off the expenses. Similarly, if you were rehabbing the property and it was vacant for 6 months, you wouldn't use 50% of the expected rental income.

Your CAP rate equation is extremely flawed if you're using a net income based on total income minus taxes. There are tons of other expenses that need to be accounted for. Insurance is the most obvious one, but vacancy, cap ex, management fees, maintenance, etc. all should be included in the expenses.

A quick sniff test for a CAP rate formula is whether the expenses are in the 40-60% range of the income. In your case, that would be about $4000-$6000. You're using $1200 which is way too low!

But Mike, I don't HAVE maintenance expenses. There are none. I bought the house cash, and I owner financed it to my end buyer. My only expense is taxes. The end buyer maintains it. 

I was just wondering about a potential vacancy ie if I did have to foreclose on her someday? and, it WAS vacant for 2 months after I bought it until I found a buyer.....thanks alot.

when I say 'all my houses are owner finance,' I mean, I own them cash, and I owner financed them. Sorry if I did not make this clear. Thanks.

CAP Rate should be a reflection of all related expenses and income one could be exposed to on an asset regardless of the existing situation or arrangement.

Therefore, the following breakdown is always considered:

GOI (All existing revenues generated from the Asset - NOT Pro-Forma)

- Vacancy Rate / Concessions (Local Market Driven)

- Property Management Rate (Local Market Driven)

EGI (GOI minus Vac/PM)

::break::

Expenses (All existing / historic normally occurring and certain projections)

- Utilities 

- Property Taxes

- Property Insurance

- Maintenance Reserve Account (normal wear and tear)

- CapEx / Reserve Account (life limited replacement items)

- Legal Expenses (CPA, Attorney, Tax Reconciliation, etc.)

- CAM (Common Area Maintenance items like yard care, snow removal, parking pavement, exterior amenities, etc.)

- Payroll and G&A Expenses

- Advertising Expenses

- Any other expenses related to the Operation of the Asset not covered above EXCEPT Debt Service, Depreciation, Income Taxes and Specific Tenant Improvements

NOI (EGI Minus all Operating Expenses)

::break::

Now you can calculate your existing CAP rate

You can also set up another file for value added opportunities that would contain Potential EGI and Potential Expenses which then would give you a Value Add potential CAP Rate

To derive your NCF, subtract your Debt Service from the NOI.

Hope that helps!/

thanks, but my question still stands :). The only expenses I have other than taxes are in my original question - 

- the initial vacancy after purchase before I owner financed it (2 months)

- potential vacancy if I have to foreclose

- foreclosure legal expenses (500 to 1000 in this area). 

thank you :)

@Account Closed  The point was it doesn't matter what your specific case is.

IF all you want to account for is what you are expressing, then use the breakdown above, insert your specific numbers where applicable and do the math as outlined. If you want to leave out an item, then so be it but it doesn't change the formula.

Just know, when you go to sell, your CAP and an Investor's analysis CAP may be far apart from each other...so just set your expectations accordingly./

got it. thanks. 

By the way, as a "Lender", which it appears you are now, one doesn't use CAP but instead simply ROI so I'm not sure where you are going with this.

IF you sold the property and gave the Buyer an Owner Financed Mortgage, then you no longer have any rights to sell it and therefore CAP calculation wouldn't be necessary as the "Owner/Borrower" should be responsible for everything included the taxes which for some reason you are still paying so I will assume you opened an Escrow Account for the Owner/Borrower.

The only "reserve" you may want to put aside if enough to handle a Foreclosure if need be. 

If you have to foreclose, then the cycle would start all over again from the outline I made above./

Yes, taxes are indeed escrowed. I pay them. That's how we set it up in our market. Thanks for the explanation, very helpful. 

https://www.easyrentaltools.com/index.cfm?event=article&title=what-is-net-operating-income

Let's say you are buying a $50,000 NOI. You determine the market is buying that NOI at a 8% cap rate. Market value would be $625,000. Now if you have 2 properties under consideration but one will need a new roof this year that cost $20,000 you would subtract that amount BELOW the line (after the NOI was capitalized ). You would NOT capitalize the one year expense.

Thank you bob. 

Originally posted by @Account Closed :

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....

....

So total revenue after taxes is $8457. 

8452/51000 = 16.6%. Seems simple. 


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):

http://www.biggerpockets.com/renewsblog/2010/09/02...

30 year note, I should have mentioned. Very good info J thanks. 

It gets even more interesting, when you consider that the buyer could pay me off  in year 3 or 5 or whatever. It does not usually happen in these deals in my experience here, but it could happen. 

The owner finance buyer paid me $5000 down, 9% interest, $46,000 total financed. Thanks. 

I would not worry about vacancy too much.  

Hopefully you qualify your buyers and get a solid down payment and never have to FC.  If it does go to FC all of your FC expenses get added up with the note balance as part of what you are entitled to as a lender.  Depending on the loan balance and the current value of the property it is possible that you will get paid off at the FC auction.

If not, then you can re-market the property and hopefully get a down payment from a new buyer that covers the renovation and vacancy costs.

Too, don't forget to back out the buyers down payment when you calculate the return since that money is no longer invested in the deal.

Originally posted by @Account Closed :

The owner finance buyer paid me $5000 down, 9% interest, $46,000 total financed. Thanks. 

So, you bought the asset for $51K and then turned around and sold it for $51K at 9% interest over 30 years. So, essentially, your ROI is about 9%...technically a tiny bit less as you fronted $5000 for some period of time that you got no incremental return on.

And if the buyer pays off the loan early and there is no prepayment penalty, you'll actually make less than 9%...especially if he pays it off very quickly...

I'm curious why you're not lending out the money instead...should be much easier to earn more than 9% that way.