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Why a Buy and Hold Investor Should Care About CAP Rates

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If you have spent any time researching “buy and hold” real-estate investing (buying a property, renting it out, and collecting positive cash flow), you have likely heard the term “CAP rate” thrown around.

“What’s the CAP rate on this deal?”

“Hey, take a look at this fantastic 6.5 CAP!”

“I’m looking for a Net 7 CAP”

“What are the CAP rates in this area?”

So… what exactly does CAP rate mean? How is it Determined? And why should a “buy and hold” real estate investor care?

First, here’s the technical definition: The capitalization rate, often just called the CAP rate for short, is the ratio of Annual Net Operating Income (NOI) to property asset value.

Great…. and what in the world does that mean… in English please?!? Let’s translate all that jargon into an example:

  • Let’s say you find a property listed for sale for $100,000, and after going to see it, you can see that it needs no additional money to fix up. It’s in perfect condition.
  • Even better, there is already a tenant living in the property who just signed a new 12-month lease paying $1,000 per month in rent.

That’s $12,000 of Annual Gross Rental Income ($1,000/month x 12 months)

  • You then research all of the likely monthly operating costs for the property (taxes, insurance, property management, vacancy, and maintenance), and you determine those costs will be $400/month

That’s $4,800 in annual operating costs ($400/month x 12 month)

  • With your Gross Rental Income and your Operating Costs in hand, you can now calculate your Net Operating Income (NOI) = $7,200

Gross Income of $12,000 less annual operating costs of $4,800 = $7,200 NOI

  • Now you have everything you need to calculate the CAP rate for this investment.

$7,200 NOI/$100,000 Property Asset Value = 7.2% CAP rate (also referred to as a Net Cap Rate of 7.2)

You’ll notice there is no placeholder for the cost of debt service (i.e. mortgage payments) in the CAP rate calculation. The reason for this is that the cost of debt service used to buy a property can vary dramatically for a number of reasons, including the timing of the property purchase, the credit score of the investor, the interest rate and points charged by financial institution providing the loan, etc. If you plan to use financing, you can calculate that cost separately.

Why should a “buy and hold” real estate investor care about CAP rates?

As a real estate investor, the CAP rate gives you the most objective and consistent means to evaluate buy and hold investment opportunities, and to compare one investment option against another. When evaluating a new opportunity, you should always be able to obtain reliable data for your CAP rate calculation through property tax records, the seller or seller’s agent, and the web (i.e. Zillow, Realtor.com, Hotpads, etc.) to determine expected costs and rental rates. (By the way, if you can’t easily determine all of those numbers, or if the seller won’t provide them to you, RUN AWAY AS FAST AS YOU CAN!)

REIMidwest provides turnkey buy and hold investment properties in the Milwaukee area. Our investors receive fully renovated properties, with carefully screened tenants already under lease for a minimum of 12 months. We provide our investors with CAP sheets for each of our properties that include REAL numbers taken from the most recent tax records, up-to-date insurance quotes, accurate property management costs, property maintenance estimates based on data from our other properties, and standard vacancy rates for the market.

Regardless of whether you decide to invest with a turnkey investment firm like ours that provides this information, or on your own, it’s important to make apples-to-apples comparisons when considering purchasing cash-flow producing properties. Give this formula a try moving forward, and on any current real estate holdings you have now. It will definitely help you make more objective buying decisions, and may even make you consider selling off those assets that aren’t performing as well as you thought.