What About
“ Cap Rate ?”
By Bruce Kellogg
It ’ s a popular and confusing measure ...
It ’ s probably the most used real estate investment metric lately . Many people , syndicators and trainers especially , are talking about it . It turns out that there are more than one version of it , and they are not consistent . So , here goes .
Realtor . com ’ s Version
Realtor . com describes Cap Rate as “ How much you earn on an investment ”, and they measure it as Net Annual Income divided by Purchase Price , expressed as a percentage . They say to calculate the annual rent , but what if there are coin laundry machines , and the garages are rented extra , or rented as storage units ? Do you see the problem here ? Now , should the Purchase Price include closing costs , and the new roof that was installed immediately after closing ? Do you see the problem here ?
One thing all versions have in common is that debt on the property is not included . It is computed as though there is no debt . That is how Cap Rates can compare properties with eachother . So that ’ s good .
Realtor . com quotes a Realtor and attorney who says , “ Cap Rate is a proxy for determining the risk of an investment .” Hmmm ... more on that shortly .
Realtor . com says Cap Rates usually range from 4 % to 12 %. A lower rate makes the property more expensive , usually .
Investopedia ’ s Version
Investopedia regards Cap Rate as a “ rateofreturn on investment ” that can be used to “ compare similar real estate investments ”. It “ indicates the property ’ s
intrinsic , natural , and unlevered rate of return .” Yes , intrinsic and natural . We like that !
So , Investopedia says Cap Rate = Net Operating Income divided by Current Market Value . Except when it says Net Operating Income divided by Purchase
Price . The first one differs from Realtor . com ’ s definition , but the second one is the same . Clear now ?
Some sources say to use actual rents and expenses from the previous year to compute a Cap Rate . Nowadays with so much syndication going on , they go beyond that to PROJECTING income , costs , and Cap Rates out three , five , seven years for the life of the project . One prominent national syndicator with about 30 projects recently said he likes to buy in the 5Cap range , add value , then sell in the 3Cap range . Now that multiunit sales are 5Cap or higher due to
increased interest rates and wealthy clients becoming less wealthy anymore , he might find his model being a challenge . Cap Rates generally rise as interest rates rise , and as Yogi Berra famously said , “ Predicting is risky , especially when it ’ s about the future .”
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