Investor 101: What is Cap Rate?

I’ve only been helping other investors buy property since the early in 2019, but I’ve been buying properties for my own investment portfolio since 2001. I’ve started this Investor 101 series to help explain some of the things that I have learned, which I find new investors really need to know but don’t know to ask.

This first article in the series is about the “Cap Rate.” By far, the cap rate is the most important number that you should know as a new investor.

The Farm Analogy

Cap rate is the most useful number that a new investor can know. By understanding this number, you will begin to select better investment properties and take control over your portfolio. “Cap rate” is short for “capitalization rate.” This is the speed at which a building converts its inherent value into cash.

Think of a building like a farm. If a building were a farm, then the cap rate would be the amount of money you could make by selling the crops each year. Just like a farm, when you sell the crops from one year, the farm will grow new crops the next year, and the year after that, and it will continue to provide cash for the farmer.

A farm can produce a lot of crops (and a lot of cash) or very little. How much it produces is evidence of many things, like the quality of the soil. Like you can learn a lot about the farm from its annual yield, you can learn a lot about a potential investment from its annual capitalization. This number can help you understand how often the building is rented, whether the building is over-priced, or whether the building might have some hidden risks.

What is a good cap rate?

Cap rates in Bakersfield range between 5% and 12%. I like to buy properties at 10% or 11% cap rate. The properties that have a 12% cap rate generally require too many repairs for my personal taste; they are too risky. The properties priced at 5%, 6% and 7% are often over-priced, in my opinion. These properties are usually lower risk, because they have been rehabbed, but I have investment goals, and these properties do not generate a high enough return for my money (at least not while there are similar properties that offer more.)

You must decide for yourself what cap rate is right for you. You will make this decision with your realtor by looking at properties for each rate, and making a judgement about what is right for you.

Cap Rate simplifies the analysis

Cap rate does not ask questions about financing. By using a number that has very simple components, you create a method of comparing properties regardless of how they are financed. This means that the cap rate for one investor is the same as the cap rate for another investor. This is very different from other metrics like the ROI.

When you become more advanced as an investor, you will start using ROI or the “Return on Investment.” This calculation is unique for each investor. An investor who uses all cash to buy a property will have a different ROI than an investor who only puts 20% down and finances 80%. Even though the ROI will be different for each of these investors, the Cap Rate remains the same for both, which makes comparing properties easy for investors who want to talk to other investors.

How much money will I get?

You can use the Cap rate to estimate your gross rent receipts. To estimate your gross rent receipts, multiply the price of the building by the cap rate. For example, a $100,000 building that has a 5% cap rate will produce $5,000 every year in gross rents. And, a $100,000 building that has a 12% cap rate will produce $12,000 ever year in gross rents.

What about profit?

Cap rate does not tell you the amount of profit you will make. Profit requires you to consider your income as well as your expenses, but cap rate only considers income. What this means is that a lower cap rate might be more profitable than a higher cap rate. However, although this situation can exist, it is a rare occasion that a lower cap rate will outperform a higher cap rate.

An example…

Let us consider the $100,000 property with a 5% cap rate again. Let us assume that there are no maintenance costs or expenses and this is all profit. This property would generate $5,000 in profit every year.

If we consider the $100,000 property with a 12% cap rate, we will see that this property can have less profit if it has $8,000 in annual expenses and maintenance.  The 12% cap rate tells us that we are receiving $12,000, but if we are spending $8,000, we only have $4,000 of profit left at the end of each year.

This is the kind of assumption that the seller is hoping that you will make. The investor hopes that you will assume the 5% property, which usually has been recently rehabbed and looks brand new, will have a $0 maintenance budget. It won’t. The seller also hopes that you assume the ugly properties selling at 12% cap rate will have an extraordinarily high maintenance and repair budget. They won’t.

My rule of thumb about expenses

On average, one can expect to spend 2.5% of the properties value each year on maintenance and repairs if you wish to maintain the property in its current condition. I usually set my repair budget at 5% of the property value for the first five years. By doing this, I can buy a property that has a higher cap rate and improve its condition slowly over time.

Final Thoughts

Skilled investors must exercise their brains and become comfortable with numbers and percentages. Investors will often throw numbers and percentages around in conversation, and as a savvy investor, you will need to keep up. However, if there is only one percentage that you understand, it should be the capitalization rate (cap rate), because this percentage conveys a lot of information about a property and is the same value for all investors who are considering a property. Using this value, you can start conversations with other investors that you would not otherwise be able to enter.