Next to the Apples and Oranges

BananaOK, since I mentioned it yesterday, I suppose I should explain what the cap rate is. More formally called the capitalization rate, like the gross rent multiplier, it is used as a tool to compare one property to another.

The cap rate is a ratio between the cash flow produced by a property and its original purchase cost. To find the number, you must first subtract all of the expenses from the amount of rent a property generated in a year. Do not factor in the mortgage payments. The remaining balance is called the net operating income or NOI. You then divide this amount by the original purchase price of the building. More simply stated: annual cash flow/cost.

For example, let’s say you paid $200,000 for a duplex. Every year, it takes in $24,000 in rent (we’ll pretend it was occupied 100% of the time). You had, oh, say $7500 in the total annual water bill, insurance, repairs, rand real estate tax and advertising. $24,000 – $7500 = $16,500 as your net operating income. You would then divide $16,500, by the total purchase cost of $200,000, giving you a cap rate of 8.25.

A cap rate can be used as a way to determine how fast an investment will pay for itself. If the cap rate is 10, then 10 percent of the purchase price will be paid back every year, with the total paid off in 10 years. Or, you can also think of a cap rate as the rate of cash return on the property if it were entirely paid off.

The rule of thumb here is the higher a cap rate, the bigger the return on the investment. Be forewarned, however, most properties with high cap rates usually have a higher degree of risk. They are often found in neighborhoods with greater management demands, or, in a property with a great deal of vacancies.

Cap rates for duplexes and small multi-family properties are usually very low. The cap rate is a much more accurate measure when applied to larger, commercial properties.