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Discussion > What is a "cap rate"?

"Cap rate" is short for Capitalization Rate which indicates the return on a property if you were to purchase it all in cash. Very rarely do real estate investors purchase a property all in cash, but the the cap rate is a standardized metric that is very helpful for investors to determine if the property/asset provides a good enough return on their investment dollars.

To put it in even simpler terms, the cap rate could be compared to the interest paid on money in a bank. If someone with $100,000 put their money in the bank and received 4% interest on their money, they would get a $4,000 Return on Investment. If the same person instead purchased a $100,000 property all in cash and was left with $4,000 at the end of the year after all expenses on the property were paid, the property would have a 4% cap rate ($4,000 / $100,000).

Cap rates are determined by taking the Gross Income of the property and subtracting all expenses (not including the mortgage expense). The number you are left with is the Net Profit. You then divide the Net Profit by the Purchase Price and you have your Cap Rate which is expressed as a percentage.

I've always found that examples are the best way for someone to wrap their mind around a new concept so I've included one below.

Purchase Price: $1,000,000

Income
Rent: $115,000
Laundry Room: $2,500
Total Income: $117,500

Expenses
Property Tax: $26,000
Repair/Maintenance: $4,800
Water: $4,000
Hydro: $3,000
Insurance: $3,000
Superintendent: $3,600
Waste Disposal: $1,500
Total Expenses: $45,900

Net Profit: $71,600

Cap Rate = $71,600 / $1,000,000
Cap Rate = 7.1%

Although it may appear intimidating at first, determining a property' Cap Rate is actually a very simple process once you've had a little experience with it.

Happy Investing!!

June 29, 2012 | Registered CommenterPaul Kondakos

I always use the cap rate measure to evaluate potential properties, thus giving me a measuring stick of the right price to pay. What puzzles me is when an appraisor comes in and evaluates a multi-unit property they use the market comparison approach and totally ignore the cap rate measure. Seems to me evaluating the true value by using cap rate is a more representative of it's true market value especially from an investor's perspective. What's your take on it?

August 30, 2012 | Unregistered CommenterChristian

Hi Christian,

There are three methods that can be used by appraisers to arrive at a valuation:

1. Sales comparison approach
2. Income approach
3. Cost approach

With older multi-unit residential properties appraisers typically exclude the cost approach and rely on the other two approaches.

The sales comparison approach is fairly straight forward as it looks at the sale prices of similar properties to the subject property to arrive at a valuation.

The income approach uses the properties income minus expenses to arrive at a net income. This is where the cap rate actually does come into play. The appraiser must assign a cap rate in order to arrive at a valuation (The cap rate is determined by the area and type of property). For example if the subject property nets $100,000 and the appraiser assigns a cap rate of 6%, you arrive at the valuation using the following formula: NET / CAP RATE = VALUATION.

That being said, I think I know what you are getting at. Why do appraisals tend to come in below market value? The answer to that question usually lies in the way appraisers use the income approach. In the income approach, appraisers are very conservative and include expenses that others might not include such as vacancy or property management and they will typically assign a higher cost to repair and maintenance and superintendent expense. These higher expenses result in a lower valuation. The reason for the discrepancy is that the appraiser will use industry standards instead of actual costs in most cases.

Hope this helps to clarify the why appraisals tend to come in light from time to time.

August 31, 2012 | Registered CommenterPaul Kondakos