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.
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