What is a Cap Rate?
Cap rate is short for ‘capitalization rate’ and it is the relationship between the income and price of a real estate investment. Since each property is unique, cap rates enable you to compare different properties with a common metric and determine which one gives you a better return. It’s a measurement of unleveraged yield, and also an indicator of perceived risk. Cap rates allow you to look at a variety of properties on an “apples-to-apples” basis.
The formula is as follows:
CAP RATE = NET OPERATING INCOME / VALUE
On the surface, it looks relatively simple; however, the cap rate calculation is a bit more complex than it seems. First, you must determine the actual net operating income, which means excluding non-operating expenses such as loan payments, depreciation & amortization, etc. and making sure to correctly distinguish between recurring expenses and capital improvements.
Owners thinking about selling can look at the cap rates of other recent sales in the area to get a general idea of what their property is worth by using a variation of the same formula:
VALUE = NET OPERATING INCOME / CAP RATE
But the cap rate, however, usually doesn’t tell the whole story because it doesn’t account for leverage. The cap rate only shows the true return on investment for an all-cash purchase. Most investors buy with leverage, so their purchase isn’t entirely based on cap rate, but rather on cash-on-cash return (also known as return on equity.) When you introduce leverage into the mix, the yield becomes a function of the net cash flow after debt service, relative to the amount of down payment. This means that interest rates play a huge part in determining how much a buyer will make on an investment, and consequently, how much they are willing to pay for it.
If this all sounds very confusing to you, don’t worry, you’re not alone. When trying to determine the right price at which to buy or sell, talk with your advisor and be sure to take into consideration more than just the cap rate.
Stay tuned for More On the Economics of Rental Retention and How Keeping Residents Happy Drives Profit. In Future Newsletters, we’ll break down more on the economics behind tenant retention and look at how applying strategies to reduce turnover will have a positive impact on your profits, operating budget, and long-term success as a rental property manager.
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