One of the most misunderstood, but important, terms in real estate investing is the Capitalization Rate or cap rate for short. This key metric is at the heart of all income property investments and allows investors to compare multiple properties to one another by taking into account their expense load. Unlike the GRM which only accounts for a property’s Purchase Price and Gross Scheduled Income (GSI), the CAP Rate also accounts for a property’s expenses, with consideration for operational efficiencies or mismanagement as the case may be.
CAP Rates are basically the savings rate or yield of a real estate investment in which you pay all cash. For example, a 10% CAP property would yield a 10% cash-on-cash return if you purchased it with cash and no debt. You calculate a property’s CAP rate by simply dividing the Purchase Price by the Net Operating Income (NOI).
When calculating a CAP rate, it’s important to properly account for expenses. Since your NOI is calculated by subtracting your expenses from your GSI, understating expenses will overstate your NOI and thus your CAP rate, making the investment appear better than it truly is. The key is to make sure that you verify as many actual expenses as possible (taxes, utilities, management, etc.) and predict others as realistically as possible (maintenance, reserves, etc.). Your goal should be to arrive at a realistic CAP rate for the investment during your Due Diligence period so you can determine whether or not to move forward with the purchase.
One core real estate investment strategy when buying income property is to identify positive leverage situations where your CAP rate is greater than your borrowing rate, or interest rate. After all, if you could borrow money from a friend at 6% and invest it at 10% you’d make 4% on every dollar borrowed. The same holds true with real estate, where your goal is to invest as much capital as safely as possible in these positive leverage situations.
It’s important to note that CAP rates move in the same direction as interest rates, so as interest rates (borrowing rate) increase, so do CAP rates, and vice versa. Interest rates are currently at historic lows and so are CAP rates, meaning the return or yield you earn on real estate is low relative to historical norms. However, this has to be taken in context with other available investments, such as the stock market (negative in 2009) or a traditional savings account at your local bank (offering around 1% in 2009). When compared to other traditional investment classes, the yields in real estate look quite attractive.
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