The “cap rate”, short for Capitalization Rate, is the most common metric of the rate of return on an investment property. Essentially, it’s meant to tell you how profitable a property is and agents often reference it on listings.
Unfortunately, calculating the cap rate is not as standardized as one would hope and thus it is easy to manipulate and mis-calculate.
Cap Rate and the “GRM” (gross rent multiplier) are often mixed-up.
The GRM is a # calculated by dividing the property value by the annual GROSS income.
~A $1m apartment building that earns $100k a year in rent has a GRM of 10
The CAP is a % calculated by dividing the annual NET income by the property value.
To get the CAP, we must subtract ALL of the annual expenses (recurring and nonrecurring) and then divide. Using the 50% rule (that half of the gross rental income should be used to pay for operating expenses) that $1m apartment building would have $50,000 per year in expenses.
~A $1m apartment building that earns $100k/yr and has $50k in expenses= has a 5% CAP.
The 50% rule does not always apply, so it is important to look closely at the cost of utilities, maintenance, capital improvements, property taxes, fees, and the volatility of the rental market.
It’s important to scrutinize the “listed cap rate” and find out exactly how it was calculated.
Often the “listed cap rate” is calculated using a low property tax basis (this happens when the building is owned for decades by the same person). Upon purchasing the property, your property taxes will be based on your purchase price, which could be much higher, making a high cap rate much lower once you own the building.
A higher CAP isn’t always better: A listing with a low cap rate could mean the owner has done a lot of maintenance and improvements. Whereas, a listing with a high cap rate could mean that the owner is under spending on maintenance and improvements. In this example, the property with the lower cap rate would be the better investment.
Moral of the story: Educate yourself. Do your homework. Dig deep. Keep your eyes wide open. Do the Math.