Not a big ol’ nerd for personal finance and real estate like I am?
No sweat. We’ll keep the math simple.
After all, math is a lot more fun when you’re calculating your future riches, right? Break out a cocktail napkin (and a cocktail to match), because it really is that simple.
What’s a Cap Rate, Anyway?
A property’s capitalization rate, or cap rate for short, is the ratio of its annual net operating income (NOI) to its price.
Put more simply, it’s the return you could expect to earn from a property, if you paid all cash for it. Here’s the formula:
So, if you’re looking at a property priced at $100,000, and the annual NOI is $10,000, then the cap rate would be 10%: $10,000 annual income / $100,000 price.
Pretty easy, right?
Okay, But How Do I Calculate NOI?
Net operating income is the total annual rents (gross income), minus the following expenses:
- Property taxes
- Vacancy rate
- Property management fees
Notice that mortgage interest is not included. Likewise, closing costs are not included with the purchase price. Borrowing costs are not a part of this calculation.
Let’s continue our example above, with the $100,000 property. Let’s say the property rents for $1,500/month, for a gross annual income of $18,000. To calculate the net operating income, we’ll subtract out:
- Property taxes: $1,000
- Insurance: $1,000
- Maintenance/repairs: $2,400
- Vacancy rate: $1,800 (10%)
- Property management fees: $1,800 (10%)
Which totals $8,000 in operating expenses, so $18,000 gross income minus $8,000 in operating expenses leaves the property with $10,000 net operating income.
See? This is third grade math. Maybe second grade for the gifted-and-talented crowd.
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Why & When Are Cap Rates Useful?
Cap rates are an easy, quick-‘n-dirty way to evaluate potential return for a specific property. While still based on estimates and projections, cap rates make for simple way to evaluate potential investment properties. They’re particularly useful for multifamily properties.
You can use cap rates to compare similar properties. If two nearly identical properties in the same neighborhood have different cap rates, one might be a better investment.
But keep in mind that might also indicate that the property with the higher cap rate has higher risk. Perhaps the renters are lower quality? Perhaps the turnover rate is higher? Or perhaps the seller knows something about the building that you don’t.
When Are Cap Rates Not Useful?
Sure, cap rates make for a good calculation you can do on a cocktail napkin, but they have plenty of limitations.
To begin with, they don’t include the cost of financing. What if you can secure better financing for Building A over Building B? That could mean a lower interest rate, but it could also mean a lower down payment.
And speaking of down payments, your cash-on-cash return is ultimately a more useful number. If you’re putting up $15,000 in cash for a deal, what annual return can you expect on that cash?
Cap rates only look at the building’s potential performance, not the returns you personally can expect on your money. Calculating out a detailed cash flow projection, showcasing all of your monthly expenses (including your mortgage payment) will give you a more accurate sense of your potential return and true monthly reality of managing that property.
Using Cap Rates to Calculate Value
Imagine you’re considering buying a multifamily building. Say you want a cap rate of at least 10%, and the NOI is $25,000. By working backwards, that means the absolute most you should spend on that building is $250,000. ($25,000 / .10, seriously don’t stress over this math!)
If the seller is asking $275,000, at least you know where to draw the line for your final offer, when negotiating.
Similarly, if you know the seller’s rock-bottom price and your own minimum cap rate, you can then evaluate whether the property’s rental income is sufficient.
And who knows? Maybe you can find ways to improve the net operating income, with a few strategic upgrades, to coax a better return out of the property.
What’s a Good Cap Rate?
Talk about a loaded question! Do you really expect us to answer that? Well, okay, maybe just a little.
Real estate comes with risks and labor that most other investments don’t. Consider U.S. Treasury bonds that pay a 3% return – these are practically risk-free and labor-free. When investing in rental properties, you need to account for the extra risk and labor that come with them.
This is known as “risk premium”: the extra return that you can expect to earn from a given investment, over a virtually risk-free investment such as a Treasury bond. If a risk-free investment pays 3%, and an income property has a potential return of 7%, then the risk premium is 4%.
And what about a labor premium? You could invest in a mutual fund, and not have to hassle with tenants calling you at 3AM to scream that they saw a cockroach.
Personally, I would urge you not to invest in any residential property that won’t deliver at least an 7-8% return. Otherwise, the juice just isn’t worth the squeeze. But for Class A, extremely low-risk properties with minimal headaches, lower returns may be acceptable.
Only as Good as Your Expense Accuracy
Capitalization rates are not the be all, end all metric for evaluating income properties. But they’re useful in comparing similar properties, and as a quick shorthand glimpse into potential returns.
Cash flow calculations and cash-on-cash returns make for better evaluations, but they too are only as good as your expense forecasting. If you estimate a 5% vacancy rate and $1,000/year in repairs for a property that actually has a 15% vacancy rate and costs an average of $3,000/year in repairs, you’re going to lose money.
If you want to get the most out of cap rate, cash flow and ROI projections, make sure your expense estimates are accurate. When in doubt, round up on vacancy rates and repairs in particular.
And we meant what we said about doing these numbers on a cocktail napkin. Just don’t forget the cocktail.
Do you use cap rates when evaluating prospective rental properties? What’s been your experience with them? What’s your favorite cocktail to drink when calculating them? Mine’s a southside, by the way.
Keepin’ It Simple: