# Capitalization Rate

The cap rate is the cash on cash return you would get if you owned an invesetment property free and clear…correct?

If the cap rate is .88% - that would be bad.

if it’s 8% - that is good.

right?

The Cap Rate is defined as the Net Operating Income divided by the value of the property (or the purchase price of the property).

Net operating income is found by subtracting the operating expenses (which does not include the mortgage payment) from the gross rents. If there is no mortgage payment, then your net operating income becomes your cash flow. If we are using purchase price in the cap rate formula, then yes, cap rate is theoretically the cash on cash return if you owned the property free and clear. As you said, a higher cap rate is better than a lower cap rate. However, is .88% bad and 8% good - that depends!

As you can see from the formula, the cap rate is a formula based on the net operating income and either the purchase price or value of the property. To make things easy and to be relevant to cash on cash return, let’s just assume that we’re talking about purchase price.

Now, for the matter of NOI. Who gets to say what the NOI is? The seller? The buyer? The realtor? Who? What expenses did they include in their calculation? Did they include all the real world expenses or guru numbers from their expensive guru course or maybe they think that the only expenses are taxes and insurance! Don’t laugh, many beginners believe this and I even received an ad from a national guru that said that listed taxes and insurance as the only expenses.

Let’s use a real world example. I have a six unit apartment building. I paid \$88,500 for the building and the gross rents are \$2,270 per month or \$27,240 per year. For simplicity, let’s just say that the taxes are \$1,400 per year and the insurance is \$1,000 per year. Let’s also say that maintenance is \$1,400 per year, vacancies are \$1,400 per year, management is \$2,800 per year. The mortgage payment is \$700 per month or \$8,400 per year (20 year loan).

What is the Cap Rate?

1. If I’m a brand new newbie or a silly guru, I might think that the only operating expenses are taxes and insurance. The NOI would be:

Gross Rents \$27240
Taxes - \$ 1,400
Insurance - \$ 1,000
--------------
NOI = \$24,840

Therefore, in this case the cap rate is \$24,840 divided by \$88,500 equalling .28 or 28%. I"M RICH, I’M RICH!!!

1. Now, let’s use the typical guru formula to figure NOI:

Gross rent \$27,240
Taxes -\$ 1,400
Insurance -\$ 600
Management -\$ 2,800
Maintenance -\$ 1,400
Vacancy -\$ 1,400
--------------
NOI = \$ 19,640

Therefore, in this case the cap rate is \$19,640 divided by \$88,500 equalling .22 or 22%. I"M STILL RICH, I’M STILL RICH!!!

1. Now, let’s forget this silliness and use real world numbers.

Throughout the entire United States operating expenses (including capital expenses) run 45% to 50% of the gross rents. For simplicity, let’s use 50%. Therefore, operating expenses would be 50% of \$27,240 or \$13,620.

Gross rents \$27,240
Operating Expenses -\$13,620
-------------
NOI = \$13,620

In this real world case the cap rate is \$13,640 divided by \$88,500 equalling .15 or 15%. Still pretty good! However, I do not own this property free and clear, so maybe we should think about the mortgage payment!

You can see from these examples that the NOI can vary greatly depending on the expenses
that are included in the calculation. Someone in fantasy land could easily think that the NOI was double the real NOI. Additionally, not many people have all their properties paid off, Therefore, you still must deduct the mortgage payment to determine your cash flow.

Also keep in mind that this is a real property. I bought it dirt cheap. The monthly gross rents are 2.5% of the purchase price. Most people have properties that only have gross rents of 1% of the purchase price.

The point to this entire post is that cap rate is just about meaningless. The cap rate is entirely decided by the expenses that are plugged into the formula. Additionally, most people do not pay cash for their properties. I prefer to simply judge a property with a cash flow analysis and I simply plug in operating expenses at 50% fo gross rents. This is very accurate and is not subject to the silliness of trying to determine the actual expenses.

Mike

Remember that cap rate is just one variable in a formula for determining return or value. If you flip that formula around it can be useful in estimating the value of a property. As previously stated cap rate = NOI/Sale Price. With a little algebra the formula can be rewritten to sale price = NOI/cap rate. Thus if you are property shopping and can compile good NOI numbers plus estimated cap rates based upon similar property sales then you can plug the numbers into the formula and get an estimate of the property value based upon its NOI and market cap rates. This formula is used by commercial real estate appraisers as part of their valuation methodology. They will typically calculate the discounted cash flow of a property for an estimated holding period which includes the NOI plus the reversion value (or sale price in the future).

It should be said also that using CAP rate to determine value is usually only used with large multi-unit properties where there are not sufficient comps to determine an alternate value. Often with any unit of 4 or less the price will be lower than the CAP rate meathod because there are comps that can determine FMV.

Mike,

Thanks for the explanation.

So, if I have a house that I charge \$1,000 in rent I can expect the expenses (before the loan payments) to be \$500 per month? Therefore, my mortgage would have to be under \$500/month to have positive cashflow?

Thanks

EXACTLY!

Good Luck,

Mike

When using the 50% expense method, it gets very hard to find properties that cash flow much, but you need to stay disciplined, otherwise you’re going to be in the business of losing money.

To achieve real growth, you need to be looking for at least a 10% CAP to keep your business growing.

Single family houses are very difficult to cashflow unless you buy them substantially under market value or rehab them. When you get to that point, your equity is so great that it makes more sense (to me atleast) to sell them and reinvest the equity, rather than collect rent. Seems silly to have a million dollar net worth yet make less than 6 figures. Just my .02!

Would you be willing to share what some of the 50% of rents will be?

Let’s say I am renting a SF for \$1200/month.

Expenses:
Insurance- \$40
Reserve- \$100
Vacancy- \$100
Taxes- \$200

This comes up to \$440 per month, plus a mort. of XX.

In this case, the expenses would be about 35% the rent. Am I being nieve with this?

Thanks

Quattro,

You completely ignored management, maintenance, evictions, exterminations, court costs, damage caused by the tenant, capital expenses, office supplies, fuel for your vehicle, legal fees, lawsuits, entity maintenance, and much, much more. The gurus will never tell you this, but you WILL experience these things in the REAL WORLD!

Mike

…and if your here in Fl. you can triple that insurance amount

I see, thanks for the insight.

Is selling under a lease option a good way to remedy these expenses?

Thanks

The best way to cover the expenses is to buy at a big enough discount so you can lower your mortgage payment (without using any gimmick loans).

Mike

One thing I’ve learned from reading a lot of posts (especially property managers), and from talking with other investors, you make your money when you BUY not when you SELL. If you didn’t make money by buying at a significant discount, you’ll have a hard time making money. If you buy at regular costs and sell at regular prices, chances are you’ll only do as well as the rate of appreciation, not to mention your property probably isn’t cash flowing on a rental basis.

So if you balance a non-cash flowing property with only apperication, chances are you’d be better throwing money in a CD at 5%. The only advantage of real estate is that you’ll have an ability to leverage, but leveraging yourself to lose money is the opposite of what the goal is.