# Exactly what does CAP RATE mean

Hello and thanks in advance to all of the investors on this site.

I’m trying to figure out exactly what a CAP RATE means. I did read the definition on this site and this is what it said:

Capitalization (Cap) Rate - rate of return used to derive the capital value of an income stream, divide annual income by net operating income.

As a newbie still I didn’t quite understand what it meant. Why is the Cap rate used?

Thanks

The Capitalization Rate (“Cap Rate”) is a ratio used to estimate the value of income producing properties. Generally, the Cap Rate is computed by taking the rental net operating income (NOI)
and dividing it by either the sales price or fair market value (FMV) of the property.

The Cap Rate is used by investors, lenders and appraisers to establish a reasonable purchase price for a given investment property in a specified market. Capitalization rates for a particular area are generally derived by analyzing the selling price, gross income and operating
expenses of comparable properties. A market capitalization rate provides a more reliable estimate of value than the gross rent
multiplier since the calculation incorporates more of a properties financial detail. The gross rent multiplier calculation only considers the sales price and the gross rents. Capitalization rates may vary in different areas of the country for many reasons such as location,
schools, level of crime and general condition of an area. Capitalization rates typically range from 8 to 12 for commercial and residential income properties. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.

Example: A property has a NOI of \$55,000 and the asking price is \$650,000.

This yields a Capitalization rate of 8.46. Net operating income in the above calculation is equal to gross income minus the vacancy amount and operating expenses. Operating expenses include such items as advertising, insurance, maintenance, property taxes, property management, repairs, supplies and utilities and do not include depreciation, interest and amortization.

if you were to pay all cash for your investment, what would your profit be at the end of the year? when that number is expressed as a %, its the CAP rate!

The original poster asked “Why is cap rate used?”

With any investment there are costs associated with it. Both real costs incurred and opportunity costs. The opportunity cost is what you lose out on by chosing to invest in ‘A’ versus ‘B’.

Here is an example. Lets say you have the options of going out to dinner with your wife OR going to a basketball game with your buddies. The cost of the dinner with your wife is 1) the amount of money you spend AND 2) the lost ‘fun’ of the game with your buddies.

As with anything the opportunity cost has to be weighed as part of the investment.

So, how does this factor in with Cap Rate? Well, one of the things that cap rate allows an investor to do is to establish a number to compare opportunity costs and real costs with. If chosing between apartment building A or apartment building B as potential investments you have to weight the return on capital and any potential appreciation or other factors that are involved. The higher cap rate is not always the better investment if the opportunity costs outweigh the difference in return. Ex: Apt A has cap rate of 9% but you estimate apprecation of 5% over the next year. Apt B has cap rate of 8% but you estimate appreciation of 10% over the next year (rents are increasing, etc).

As with any ratio or financial equation the answer alone means nothing. It’s how that answer compares to all the other factors involved. It’s just another way to help quantify data to make better decisions.

I once saw an excel sheet that someone had made where you could plug in figures, NOI, NOE, etc and it gives you ROI etc, etc.

Anyone here have a sheet like that they use?
BTW, what is the rule of thumb on the % over what your mortgage and expenses are for rental property?

Hard to say as so many variables go into each and every property. However, in general, it’s not uncommon to expect to pay 1% of the value of any given home for typical maintenance and upkeep on a yearly basis.

what is the percent over the mortgage (or of the monthly rent) that you should be pocketing after expenses?

Just hypothetical
Say 120k house, 950 mo mortgage?
what should you be pocketing each month?

At least double what you can get as a return on T-bills. (long term rate) If you can’t make at least twice the amount of money you can by simply sticking your money into a fund it’s not worth the hassle. Personally I’d aim higher, say 4x the T-bill rate… which right now is at 5.2%.

With that being said, how much you cash flow can sometimes be totally up to you. If you elect to fund the purchase via a 15 year fixed rate loan as opposed to a 30 year, you’re willing to sacrifice monthly cash flow for much less interest paid out total over the lifetime of the loan. If you’re not making at least \$100 cash flow per unit each month (not including equity buildup) then I believe you’re at risk of foreclosure if the rental market softens.

In some overheated markets the only way you can make a property cash-flow is by putting 40% down AND have an interest only loan. Investing in these areas is playing russian roulette and should be avoided.

Since you’re using an index to justify your return you should compare apples to apples. First, a T-bill is a short term security that matures in 3, 6 or 12 months that pays no interest. It’s purchased at a discount so the return is based on the discounted rate to face value. A T-Note however does pay interest (it can also be purchased at a discount or a premium or par) that is paid semi-annually.

If you’re referring to a T-Note of a 10 year maturity then lets use an example to show the rates of return for your investment. We’ll use 100k as the investment. If you purchase a T-Note for 100k then it requires a full 100k in order to purchase the security. So lets use a hypothetical return of 6% for ease of use. So after 1 year you’ve made \$6000 in interest.

Using real estate you can purchase a 100k house for (and this is VERY conservative) \$20,000 down. Lets say that same house generates \$100 per month in positive cash flow and appreciates at 3% (less than 25% of the average appreciation for real estate for the last year and less than half of the average apprecation since 1980). So in 1 year you’ve made \$3000 in appreciation and \$1200 in cash flow. By your calculations the T-Note appears better but keep in mind that you made \$6000 on \$100,000 but \$4200 on \$20000. Your cash on cash return is 21%. It’s virtually impossible to not beat T-Note return (or most any return except options or futures) because of the leverage real estate provides.

If you’re paying cash for every deal then you’re really missing out on the whole benefit that real estate provides. The leverage is the real winner in real estate and that’s why it’s created more wealthy individuals than any other vehicle.