Most investing decisions come down to math. Property evaluation is too complex without it. If you really understand the benefits and limitations of the most common investment equations, you’ll make better decisions, reduce your work load and be able to act quickly.
The best way to look at a cap rate is as a return on the value of a property. A 10% cap rate will give you 10% return on the value of the property over a single year after costs have been deducted.
How Cap Rates Work
For many investors, cap rates are the magic bullet. It’s the first thing they turn to when making decisions because it takes into account costs and income. While cap rates do give you a lot of information and help you compare properties, they also leave out a lot of information. Let’s get to the math so we can better understand how it works and how to avoid common mistakes.
Cap Rate = Net Operating Income/Value
NOI is the gross yearly income from a property minus the expenses (does not including mortgage payments, income taxes or depreciation).
- Total of all rents and other income the property produces in a year
- Vacancy loss (how much rent will you lose in an average year due to vacancies)
- Routine maintenance (yard work, painting, etc.)
- Property management fees
- Property taxes
- Utilities that you pay for
- Property is valued at $250,000
- Rental income = $18,000 a year
- Vacancy loss averages 2% for your area = $18,000*.02 = $360 a year
- All expected maintenance = $1,200 a year
- No property manager, advertising or utility bills for this property
- Property taxes = $3,000 a year
- Cap rate = ($18,000 – $360 – $1,200 – $3,000)/$250,000 = 0.054 or 5.4% cap rate
How to Interpret Your Cap Rate
Cap rates are different everywhere you go. Because value (price) is part of the equation, cap rates are based on supply and demand in your local area. In the U.S. most real estate falls in the 5%-10% range. It is possible to do better, but it usually requires creative thinking.
Cap rates have three important uses.
- The cap rate can help you understand if a property is priced too high or low for an area. All you have to do is compare the cap rate from the property you are looking at to the average cap rate for the area. An above average cap rate for an area can be an indication of problems with the property.
- If you decide you won’t do a deal unless you get a certain cap rate, then you can use it to decide what price to offer.
- If you know the average NOI (cash flow) for this deal is going to be $30,000 a year and you will only do a deal with a cap rate of 8% or higher, then you should bid $30,000/.08 = $375,000 or less.
- If you know what cap rates are common in the area and and you know the asking price, you can get an idea of the Net Operating Expenses assuming cap rates were used to price the property.
- If the average cap rate in the area is 6% and the asking price is $300,000, then 0.06*$300,000 = $18,000 in expenses for the year.
Cap Rate Limitations
- Cap rates will not help you evaluate appreciation (increase in value) or any changes that take place over time. Cap rates are a snapshot of right now only.
- Cap rates are based on very few inputs. A small error can significantly change the results.
- Cap rates do not take into account loans used to purchase the property. If your interest rate is different for different properties you cannot use it to help you decide which property is better.
- Cap rates are based on guesses as to the costs and income of a property. Try to get the actual rent and cost information from the property owner. Also, check to see if they have lower than average rents or any deferred maintenance that can significantly impact your NOI.
- Equations are only as good as the data you put into them. Make sure you’re inputting consistent average values from the area, not the values you want to see.
How to Best Use Cap Rates in Analysis
Think of cap rates as a compass. All they can do is point the right direction. They won’t give you any information about what lays ahead. I like to use cap rates to decide if I should spend more time evaluating a property, that’s it. Whatever you do, don’t let a simple division problem decide your future.
Cap rates can also be used to help you decide what type of property you should invest in. If single family is going for 5%, office buildings 6% and apartments 7%, then you should probably focus on apartments.
Just like anything in an open market, as one type of investment gets better, demand grows, prices increase and profitability drops. Cap rates follow the same trend and can change quickly. Keep an eye on them so you always know what’s going on.
Investors: To what extent do you rely on cap rates to make your decisions about properties?
Let me know with a comment!