Cap Rate: How to Best Evaluate a Property's Numbers

6/22/15 2:07 PM

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Cap Rate: How to Best Evaluate & Interpret a Propertys Numbers

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Cap Rate: How to Best Evaluate & Interpret a Propertys Numbers

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Cap Rate: How to Best Evaluate a Property's Numbers

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BIGGERPOCKETS ARTICLES HAVE BEEN SEEN ON:

Most investing decisions come down to math. Property evaluation is too complex without it. If
you really understand the benets and limitations of the most common investment equations,
youll make better decisions, reduce your work load and be able to act quickly.
The best way to look at a cap rate is as a return on the value of a property. A 10% cap rate will
give you 10% return on the value of the property over a single year after costs have been
deducted.

How Cap Rates Work

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For many investors, cap rates are the magic bullet. Its the rst thing they turn to when making
decisions because it takes into account costs and income. While cap rates do give you a lot of
information and help you compare properties, they also leave out a lot of information. Lets
get to the math so we can better understand how it works and how to avoid common

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mistakes.
Cap Rate = Net Operating Income/Value
NOI is the gross yearly income from a property minus the expenses (does not including

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mortgage payments, income taxes or depreciation).

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Gross income:
Total of all rents and other income the property produces in a year
Costs include:
Vacancy loss (how much rent will you lose in an average year due to vacancies)
Routine maintenance (yard work, painting, etc.)
Property management fees
Property taxes
Advertising
Utilities that you pay for
Related: Investment Face-O!: Rental Property With 6% Cap Rate vs. REIT With 8% Return

http://www.biggerpockets.com/renewsblog/2015/06/17/cap-rate/

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Cap Rate: How to Best Evaluate a Property's Numbers

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Example
Property is valued at $250,000
Rental income = $18,000 a year
Vacancy loss averages 2% for your area = $18,000*.02 = $360 a year
All expected maintenance = $1,200 a year
No property manager, advertising or utility bills for this property
Property taxes = $3,000 a year
Cap rate = ($18,000 $360 $1,200 $3,000)/$250,000 = 0.054 or 5.4% cap rate

How to Interpret Your Cap Rate

Cap rates are di"erent everywhere you go. Because value (price) is part of the equation, cap
rates are based on supply and demand in your local area. In the U.S. most real estate falls in
the 5%-10% range. It is possible to do better, but it usually requires creative thinking.
Cap rates have three important uses.
The cap rate can help you understand if a property is priced too high or low for an area.
All you have to do is compare the cap rate from the property you are looking at to the
average cap rate for the area. An above average cap rate for an area can be an indication
of problems with the property.
If you decide you wont do a deal unless you get a certain cap rate, then you can use it to
decide what price to o"er.
If you know the average NOI (cash ow) for this deal is going to be $30,000 a year
and you will only do a deal with a cap rate of 8% or higher, then you should bid
$30,000/.08 = $375,000 or less.
If you know what cap rates are common in the area and and you know the asking price,
you can get an idea of the Net Operating Expenses assuming cap rates were used to
price the property.
If the average cap rate in the area is 6% and the asking price is $300,000, then
0.06*$300,000 = $18,000 in expenses for the year.

http://www.biggerpockets.com/renewsblog/2015/06/17/cap-rate/

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Cap Rate: How to Best Evaluate a Property's Numbers

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Related: A Denitive Guide to Understanding Cap Rates and Cash-on-Cash Returns

Cap Rate Limitations

Cap rates will not help you evaluate appreciation (increase in value) or any changes that
take place over time. Cap rates are a snapshot of right now only.
Cap rates are based on very few inputs. A small error can signicantly change the
results.
Cap rates do not take into account loans used to purchase the property. If your interest
rate is di"erent for di"erent properties you cannot use it to help you decide which
property is better.
Cap rates are based on guesses as to the costs and income of a property. Try to get the
actual rent and cost information from the property owner. Also, check to see if they have
lower than average rents or any deferred maintenance that can signicantly impact your
NOI.
Equations are only as good as the data you put into them. Make sure youre inputting
consistent average values from the area, not the values you want to see.

How to Best Use Cap Rates in Analysis

Think of cap rates as a compass. All they can do is point the right direction. They wont give
you any information about what lays ahead. I like to use cap rates to decide if I should spend
more time evaluating a property, thats it. Whatever you do, dont let a simple division problem
decide your future.
Cap rates can also be used to help you decide what type of property you should invest in. If
single family is going for 5%, oce buildings 6% and apartments 7%, then you should
probably focus on apartments.
Just like anything in an open market, as one type of investment gets better, demand grows,
prices increase and protability drops. Cap rates follow the same trend and can change
quickly. Keep an eye on them so you always know whats going on.

http://www.biggerpockets.com/renewsblog/2015/06/17/cap-rate/

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Cap Rate: How to Best Evaluate a Property's Numbers

6/22/15 2:07 PM

Investors: To what extent do you rely on cap rates to make your decisions about properties?
Let me know with a comment!

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ABOUT AUTHOR

BRETT LEE

Brett Lee is a licensed real estate broker in Portland Oregon where he helps people achieve a
better nancial future so they can do the things that truly make them happy. Brett is also a
buy-and-hold investor, property manager, and investment advisor. Before getting into real
estate Brett was a research scientist and part time professor focusing on wetland hydrology
and water pollution at Humboldt State University.

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9 COMMENTS

ROY N. on JUNE 17, 2015 7:39 PM

Pro

Limitation:
Cap rates are not useful for residential (1 4 unit) properties as the market values these properties by
comparative sales and not by NOI.
REPLY

http://www.biggerpockets.com/renewsblog/2015/06/17/cap-rate/

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