If you own real estate that you rent to someone else, understand a real estate “cap rate”.
Here’s why it matters to you.
A real estate Capitalization Rate – or Cap Rate – is simply income divided by price.
Let me get formulaic on you. But don’t worry. I’ll get more human and tell you what this really means.
In detail, a Cap Rate is a property’s annual Net Operating Income divided by its Purchase Price (or value).
NOI / Price.
For example, your annual NOI of $30,000 divided by your $300,000 property results in a 10% cap rate.
Well, what goes into NOI? That’s the property’s rent income minus all expenses – except the mortgage.
Therefore, NOI is rent income minus the cost of:
- Property insurance
- Property tax
- Property management fees
- A factor for vacancy
- Homeowners or Condo Association dues
Notice that the mortgage principal and interest are not part of this. That throws some people off.
I’m going to tell you why it shouldn’t.
You bring a mortgage to the building. The building doesn’t have one.
Your mortgage terms are dependent upon your chosen loan amount, your creditworthiness, your locked-in interest rate, and all kinds of other factors specific to you, the borrower – not the operations of the building.
Mortgage = you, you, you.
That’s why when an agent advertises a property for sale, they can advertise the Cap Rate.
But agents cannot forecast your Cash-On-Cash Return or Cash Flow, because they involve financing.
In short, Cap Rate tells you how your property performs. It’s how much income it generates relative to how much it’s worth.
The easiest way to remember that Cap Rate does not include your mortgage principal and interest is because you brought a mortgage to the property. The property didn’t have a mortgage built into it until you came along.
Cap Rate is income divided by price. So if you can’t remember anything else, it’s simply “I” over “P”.
Would you like to hear me talk more about Cap Rate, and compare it the most important investor metric, the Cash-On-Cash Return? I discuss this in Get Rich Education Podcast Episode 98.
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I’d be interested in hearing you discuss the balance between optimizing the cap rate and the quality of the property. I have been looking at different turnkey providers, many of which you have suggested, and you can find a pretty large range of cap rates. I have to ask myself what’s the catch for the 11% cap rate property versus the 8%? Of course some providers don’t figure maintenance and vacancy into it which often prevents direct comparison.
I had a provider in OK tell me today not to look at any of their properties listed over 8.5% cap rate if I did not want to buy in a scary part of town with bars on the windows.
Thanks for the feedback!
It sounds like you’re performing your due diligence. Well done.
An excellent article: Email me the article please.