Understanding cap rates

When determining whether or not a property is worth purchasing, one of the traditional reference points is the cap rate. For real estate, a cap rate is the ratio between the yearly net operating income of a building to the cost of that building. The higher that number is, the better the deal.

When determining your net operating income, you’ll need to tally all the income from rents and other sources over the previous year. When these numbers are not available, you’ll need to use projections. If you subtract your annual expenses from this number (things like maintenance, water, sewer, trash, etc.) you have your net operating income.

Now you need to divide that number by the cost of the property. If the property you are considering is in need of repairs, it is generally best to include those repairs along with the acquisition costs to determine your cost basis. DO NOT include rehab costs in with you expenses.

Now that you have your income and property values down, simply follow this simple formula:

Annual Net Operating Income / Property Cost

The result is your cap rate. Now, don’t get too caught up into what cap rates other people are getting. If you search the internet you can see claims that 7.5% is the magic number, to only 14%-plus deals are worth considering. The truth is, you don’t know what area that claimant is based in or what they are exactly considering as expenses.

The real value of the cap rate is for personal comparisons. They do not consider financing so they don’t truly project a return on investment. They are best used to set personal thresholds of what you are looking for in your investments. For instance, with a property in Gravois Park, you might require the cap rate to be a couple of points higher to consider the property as apposed to something in Tower Grove South. Or you might be happy with a 8% cap rate for a single family, but require a 12% for a 4-family.

The key is determining your own objectives and keeping to them. Its so easy to get emotionally excited about a potential purchase that you fail to consider how much you are making for your investment. If you check the cap rate on every building you look at, you’ll always be sure that you are not making a knee-jerk decision to buy an unworthy property. And the more properties you look at; the more you purchase; the more these numbers will mean to you.

One shortcut to determine cap rates and others important numbers quickly and reliable, is to use a spreadsheet to calculate them for you. It’s a good idea to use something like this free Rental Property Analysis Spreadsheet or come up with our own. It makes life a lot easier.

For the next article in this series, we’ll get into cash-on-cash returns. The more sober sibling to the cap-rate.

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