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What is a CAP rate and why do I care?

This is an entry from the blog on my Windows Live site (http://www.jasonhershey.com/). I thought it worth repeating, since many folks don't know what a CAP rate is, how to calculate it, or how to use it. So, on to addressing that question…

What is a CAP rate and why should I care?

OK. Time for something educational. Lets talk about CAP rates and their importance in evaluating income property.

What is a CAP rate? CAP rate is short for Capitalization Rate. Now that you know, you can forget that tidbit of info. Nobody actually uses the term "Capitalization Rate".  It is calculated by dividing the annual Net Income of a property by its current market value (its current selling price). Its a relatively simple and easy way to calcualte your rate of return on an income property.  

What is Net Income? Your annual Net Income is your Gross Income less your taxes and other expenses… not counting debt expense.  You should include a vacancy rate, also. (Vacancy rate?  Ok. figure what % of the time you won't be getting rent from your property.)  

Maybe an example will help…. Let's say you are looking at buying a small apartment building with 6 apartments. Is it a good investment?  

First lets look at income Each apartment rents for $500 per month. That gives you a gross annual income, from rent, of $36,000 (12 x 6 x $500). You also happen to have a small laundry room in the building, and the washers/dryers get you another $100 per month in income ($1200 per year).  So, your total gross income per year is $37,200. Not bad.  Now, how often are your apartments empty?  Let's say you have everyone on 12 month leases, and as a general rule, people stay more than a year. You might have a vacancy rate as low as 5% (that is less than 1 month per year per unit).  That means you can count on only $34,200 for rent($36,000 -$1800 (5% of $36K)).  So your effective gross income is actually $35,400.  

Now, what about expenses? First there are taxes, lets say those are only $3,000/yr.  Then you have insurance… so lets say that is $1500 for landlord's insurance and a personal umbrella policy (in case someone trips and falls). You also have to pay your account, the lawn maintenance person, and you have to pay for the water/electric for the laundry room and the outside of the building.  Plus, you want to save up something to replace the roof in a few years… lets say you save $500 per year for that. Those miscellaneous expenses add up to about $3000 per year.  So, your total expenses are $7,500 per year.  

And the Net Income is…. The result is.. net income of $27,900 per year.  

What is the selling price? OK. So what is the selling price?  Well, for our example, lets say the selling price is $600,000. Is that good or bad?  Well, lets calculate the cap rate.  

The CAP RATE…. The cap rate is the net income divided by the selling price, or $27,900 / $600,000, or 4.65%.    Need a calculator, try this web one.. http://www.webcalc.net/calc/business/0886.php

But, what does it mean? Well, there are several ways to use this number.  One way is to compare it to the cap rate calculated for a different property you are considering buying.  If the other property has a cap rate of 6%, then 4.65% isn't very good (higher cap rate is better, all other things being equal).   Another way to look to use it is to compare the cap rate against your borrowing rate. If you are borrowing at 6.5%, then a cap rate of only 4.65% isn't really covering your debt costs.  Now, this isn't completely accurate… it works best for high states of leverage (ie, borrowing 100% of the purchase price).   If you were paying cash or have a big downpayment, then instead compare the cap rate against your return on savings.  If you can by a Certificate of Deposit (CD) from a bank at 5% interest, then a return of 4.65% from your property isn't very attractive… especially considering the CD is virtually risk free.   In some areas of the country, you won't see investors touch anything less that 10% cap rate.  In the Pacific Northwest, for small properties, its hard to find anything higher than 6%.  The latter is due largely due to the huge appreciation in base price of property for other reasons over the past few years (see "But what about…" below).    What cap rate you look for will depend on your situation and your goals. The important thing to know for now, is what it is and how to calculate it.  I am amazed to see investors and even real estate agents, who don't know how to figure out this fairly simple number.  Of course, the final number is only as good as the inputs, so its important to remember that sellers won't always fill you in completely on what hte expenses are. Once you've put in an offer, you can get the actual financial records of the property… be sure to check them.  If you are a seller, this conversation has some important implications for you also… which we will discuss at another time.  

But what about… I know some smart aleck out there is asking… "But what about the appreciation of the property, tax savings, and all that jazz?".  That is where the 'all other things being equal' statement comes in.  The cap rate is good for checking out the value of INCOME property, based on the income.  If you are investing for tax savings, for capital gains appreciate based on the value of hte property,  or for some other reason, the cap rate starts to lose some value.  At that point you may want or need to do a more complex calculation like the Internal Rate of Return (IRR). That helps you account for all the cash flows, like tax savings, selling the appreciated property, etc.  But, with that kind of calculation you also have to deal with more variables… like the rate of inflation, savings rate, etc.  Its a necessary calculation to be able to do, but that is a lesson for another day.    

So, have some fun and grab those calculators!   -Jason

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