Simply… your annual yield before debt

Everyone who invests their money wants a return on investment. This is often called “yield”. In real estate, the yield has a fancy name called capitalization rate, or “cap rate” for short.

Cap rates play a huge part in determining the value of real estate assets. They are one of the two variables needed to easily value a property — especially commercial real estate assets.

Most “buy and hold” investors purchase real estate with the goal of obtaining fairly consistent periodic payments. For these buyers, cap rate is one of the only things that matters.

What Is A Cap Rate?

Cap rates calculated using a simple formula:

(gross income - operating expenses) / purchase price = cap rate

The capitalization rate, often just called the cap rate, is the net income before debt and depreciation divided by the purchase price. That’s it.

This is undoubtedly one of the most common forms of coming to a valuation for long term investors.

So to determine a cap rate, you need to know three inputs:

1. Gross Income
2. Operating Expenses
3. Purchase Price/Cost Basis

What Are The Operating Expenses?

Every income producing real estate deal will typically have the same general categories of overhead. All regular operating expenses will fall into one of the following categories:

• leasing costs
• property management
• general expenses such insurance, utilities, etc
• maintenance
• property taxes
• credit loss – tenants who don’t pay
• capital expenditures

Of course there are subsets within each of these categories but all ongoing property expenses fall into one of these categories.

Please note that property depreciation and interest expenses are not considered an expense for net operating income calculation purposes.

As an aside, when you are evaluating expenses, never believe an owner’s pro forma. Always use third party property manager reports, audited financial statements, plus your own expense modeling to determine what realistic operating expenses are.

How to Calculate a Cap Rate

For example: If Mark wants to purchase a single family home for $150,000 that has net income of $1000 per month after all expenses. Thus, the home produces $12,000 of net income in 12 months. Divide the yearly income by the purchase price to determine your cap rate (e.g., $12,000/$150,000 = 8% Cap Rate).

Small Changes Affect Property Value

Increasing income by only $325 per month adds $65,000 in value at a 6% cap rate

Say you have a 10 unit apartment building with rents of $1,000 per month that stays around 90% occupied. Your monthly income is $9,000 per month. Your expenses are $4,000 per month, resulting in $5,000 monthly income, or $60K per year. If the market cap rate in your market is 6%, your building is worth $1M.

So, to be clear:

• Monthly rent: $9,000
• Monthly expenses: $4,000
• Net operating income: $5,000
• Annual NOI: $60,000
• Cap Rate: 6%
• Value: $1,000,000

However, let’s say that you manage to increase the rent by $25 per month per unit and reduce the operating expenses by only $100 per month. This will add $325 per month in net income, or $3,900 per year.

So your new annual NOI is $63,900. What did that do to your valuation? Your property is now worth $1,065,000. So you added $65,000 (!) in value just by increasing your NOI by only $325 per month.

How Interest Rates Affect Cap Rates

Probably the largest determinant in a property’s cap rate is interest rates. Why? This is beyond the scope of this article, but we will touch on it briefly.

There are two key reasons why interest rates greatly affect cap rates: (1) income producing real estate competes against less risky assets such as treasuries and investment grade bonds and (2) if bank interest rates are higher, more of your net income goes to servicing debt and banks will not lend unless your property meets a minimum “debt service coverage ratio”.

For #1, why would you buy a risky apartment building that takes some level of management for a 6% cap rate when you can buy 10 year treasuries for a 5%? return?

For #2, banks require a minimum ‘debt service coverage ratio’, or ‘DSCR’, of around 1.25 to 1.35. This means the property must make at least 125% your mortgage payment for them to finance it. So if your mortgage rate is higher, payments are more, so the price must be less to cover the debt service and for you to meet the bank’s ratio requirements. So you can either put more money down or pay less. Usually, buyers don’t have more to put down so naturally the price of the asset falls.

Beware of Cap Rates (Sometimes)

Cap Rates are overly simplistic and a lot more underwriting should go into any real estate deal.

For example, a lot of real estate private equity funds advertise a pro forma projected rate of return of 16-20% or even more. To achieve this, you must either have a huge amount of leverage or do significant value-add with everything going absolutely right. This is more speculation than investment.

DYOR (Do your own research) and make sure to dig in deep into the financials of the property and the background and history of success of the particular fund. Read the fine print. Don’t be afraid to ask questions! You never learn anything without asking. Never just invest solely based on what the seller or fund claims to be true. If the numbers were really that great and twice as good as anything else on the market, then why the hell would they be willing to give it up?

Cap rates can change very quickly. Real estate is a long term investment, but the cap rate at any given time can change within months or at most a year or so. You can’t buy a long term property based on a very low cap rate. This is how a lot of investors got into trouble during the financial crisis of 2008. For example, you may have purchased a class C property in Las Vegas that was renting for $650 per month to a lot of construction workers or others in the building industry. As soon as construction dried up, all these workers either lost their jobs or left so rents fell to $500 per month or less. A $150 reduction in rent is a 23% reduction in your income. This would put you in technical default with your bank and could cause you to lose the property.

Never buy something when cap rates are extremely low and rents are temporarily high. This is a recipe for financial disaster.

Cap Rates in Single Family Residential Investing

Home buyers do not think about cap rates when purchasing their homes and home appraisers do not consider cap rates when determining home values.

The single family market does not “think” in terms of cap rates, generally speaking. This is more reserved for commercial real estate investing. However, the same principals apply: cap rate = yield, your yield is simply your return on investment, and you should figure out what your cap rate would be based on how much you are paying for your property.

Larger SFR funds and institutions do use cap rates to determine purchase prices, but this mostly applies to larger packages of 50 to 100 homes or more.

You can use RealFlips to determine how much you should pay for a property using our ‘Rental calculator’. You can find this calculator on the Auction or Potential Deal details page. You plug in a few numbers, including your target cap rate and our software will tell you how much you should pay.

Conclusion

Cap rates are a useful tool for modeling a real estate investment but should be only one of multiple data points. Some other things that you should consider are replacement cost, comparable sales, local economic trends. You should also pick apart every line item on the P&L statement to see what is realistic and what could be improved.

You can find real value by finding something that is badly managed. This lets you use cap rates to your advantage. Say for example an absentee landlord has an outdated answering service that charges $200 per month when you could reduce it to something more modern for $30 per month. This small change will add $30,000 to $50,000 of value!