My long-running pet peeve with real estate investing is the extent to which some people oversimplify it.
What I’ve found over the years is that more often than not, these very same people are trying to sell you something.
Usually, it’s an online course or some prime land in Florida.
What could possibly go wrong?
That being said, real estate investing doesn’t have to be too complicated either.
As the saying goes: “If it doesn’t make sense on the back of a napkin, it ain’t gonna make sense in Excel”.
The reality is that for the vast majority of real estate deals, there’s a very simple metric that accurately predicts whether a deal will make financial sense.
It’s called the cap rate.
And thankfully, all you need to wrap your head around it is about 15 minutes of time and some high-school math, not a ten-week course costing thousands of dollars.
Defining The Cap Rate
The cap rate (shorthand for capitalization rate) is designed to calculate the unlevered rate of return on a real estate property.
It is calculated as Net Operating Income of the property divided by its price.
Net Operating Income itself (also known as NOI) is defined as rental income less expenses, such as:
- Property management
- Property taxes
- Utilities (water, heat, electricity)
- Repairs and maintenance
- Any other expense you expect to incur when owning the property
For example, a property with a $50k NOI and a $1m price tag will have a 5% cap rate ($50k divided by $1m).
Alternatively, a property with a $20k NOI and a $200k price tag will have a 10% cap rate ($20k divided by $200k).
In today’s post, I will use this second set of numbers to illustrate the key points relating to the cap rate.
Important Aside: Ignoring The Leverage (For Now)
The word “unlevered” is super important here.
What it means is that the cap rate calculation assumes there is no mortgage on the property you are buying.
Now, it doesn’t mean you won’t actually take out a mortgage on the property. You will, and you should – because leverage is the key to building wealth in real estate.
However, the first step is to estimate is the return a property would deliver in absence of a mortgage.
As I will show you below, if a property generates an attractive enough return without a mortgage, you can be sure that judicious use of leverage will amplify your equity returns.
If this is the case, you can now start playing around with mortgage interest rates and loan to value assumptions to find a way to maximize your equity returns.
We work through these examples below.
Alternatively, if a property doesn’t generate an attractive return on its own, no amount of leverage will save you. Cut your losses and move on to the next one.
Primary Uses Of The Cap Rate
There are two primary ways the cap rate is used by real estate investors.
Example 1: Using The Cap Rate To Calculate The Payback Period
This is a simple one. If a property costs $200k and generates $20k of NOI, it will take ten years to pay for itself.
You get to this number through the simple act of dividing 1 by the cap rate.
Using our example above, the property’s cap rate is 10% ($20k NOI / $200k purchase price) and the payback period is calculated as:
Payback Period = 1 / 10% cap rate = 10 years
You can also just reverse the cap rate formula and divide the purchase price by the NOI:
Payback Period = $200k purchase price / $20k NOI = 10 years
Assuming everything else stays constant, the property will pay for itself in ten years.
Example 2: Using the Cap Rate To Estimate The Profitability Of An Investment
This is a much more important use of the cap rate formula. It allows you to quickly gauge the potential equity return on your investment.
Say the property has a 10% cap rate.
Assume mortgage rates are also 10% (bear with me for simplicity) and you can get a 50% LTV mortgage.
The maths here are pretty simple:
Property nets $20k of NOI.
Your mortgage amount is $100k (50% of $200k purchase price) and costs you $10k per year ($100k x 10%) to service.
Your equity investment (i.e. the down payment) is also $100k (the other 50% of the $200k purchase price).
Of the $20k in NOI, you use $10k to service the mortgage interest. This leaves you with an equity return of $10k in absolute terms.
Given you made a down payment of $100k, your percentage return works out to 10%:
Equity Return (%) = ($10k Equity Return) / ($100k Down Payment) = 10%
Here’s a simple table that illustrates the maths above:
Scenario 1: $200k purchase price, 10% mortgage, 50% LTV
Now, an important caveat is in order.
Where most people get confused in real estate is when they run their numbers and they look nothing like what you see above.
The mistake they make is including the entire mortgage payment instead of just the mortgage interest.
In the example above, your total mortgage payment would likely be higher than $10k as it would also include a portion of principal repayment.
Let’s say that in addition to the $10k mortgage interest, your bank would also like you to repay $5k of principal every year.
Your total mortgage payment would be $15k. However, the important point to remember here is that the extra $5k is not an expense.
Rather, it’s a payment you are making so that you can take full possession of the property at the end of the mortgage term.
Now, back to regularly scheduled programming.
The Magic In Real Estate Investing
If you really want to make money in real estate, you’ve got to find properties where the cap rate is significantly higher than the interest rate on the mortgage.
Have a look at the table below.
Scenario 2: $200k purchase price, 10% 5% mortgage, 50% LTV
Assuming you were able to finance this same property at 5%, you would generate an equity return of 15k. All of a sudden, you’ve increased your equity returns from 10% to 15%.
Not too shabby.
The same dynamic plays out when you increase the LTV of the mortgage.
Below is a table showing your equity returns if you were able to finance the property at 5% AND get a 75% LTV mortgage on it.
Scenario 3: $200k purchase price, 10% 5% mortgage, 50% 75% LTV
Your absolute equity return would reduce to $12.5k on account of the higher mortgage payment.
However, you are only putting $50k down, so in percentage terms, you are now generating a return of 25%.
In other words, a reduction in the mortgage interest rate and an increase in LTV have taken your equity returns from 10% all the way to 25%.
In practical terms, this means that instead of buying one property, you can actually buy two, put $50k down on each and make $25k in equity returns a year.
Now I don’t have to tell you that it’s much better than the $10k you were making in Scenario 1 above, do I?
For those of you more mathematically inclined, the formula here is simple:
Return On Equity = (Cap Rate – Cost of Debt * LTV) / (1 – LTV)
Thus, in the final example above, the return on equity would be:
Return on Equity = (10% – 5% * 75%) / (1 – 75%) = (10% – 3.75%) / 25% = 25%
Alternatively, you can just play around with the spreadsheet I’ve uploaded here to see how different cap rate / LTV / mortgage interest numbers impact your equity returns.
Cap Rate Shortcomings
As helpful as a cap rate may be, it does have its shortcomings.
Issue #1: A cap rate doesn’t take into account growth in a property’s operating income
As those who have ever rented a property are painfully aware, rents typically go up over time.
Clearly, this isn’t unwelcome from a landlord’s perspective. Rent growth pushes up NOI and increases your cap rate.
In addition, there is often an opportunity to increase rents by bringing them in line with market rates, refurbishing a property or simply doing a better job of marketing it.
As an example, the most recent property I bought had a 5.7% cap rate in year 1, but I expect it to increase materially in the coming years.
Issue #2: A cap rate doesn’t take into account price appreciation
This is just as important. A cap rate only takes into account the income generated by a property.
You can buy a property with a low cap rate but if it keeps going up in value 5% every year, your equity returns will be much higher when you eventually sell it.
In case you ever wondered, it is this expectation of future growth in rents and prices that leads to very low cap rates on properties in cities like London and New.
Issue #3: A cap rate doesn’t take into account the kind of mortgage you put on a property
As you can see in the examples above, a 5% cap rate in a country where mortgage rates are also 5% isn’t much to write home about.
However, if you live in a place where mortgage rates are much lower – and LTVs higher, you may well squeeze out a great equity return out of a 5% cap rate property.
Issue #4: A cap rate ignores taxes
Tax rates differ depending on your jurisdiction and personal circumstances.
As such, cap rates are not designed to take those into account – but you certainly should.
In practical terms, that means you should incorporate the tax deductibility of mortgage interest and your own tax bill on the equity income in the calculations above.
Alas, this is something that differs from person to person, so I cannot really do that in this post.
Bringing It Home
As I have written before, real estate investing certainly comes with its own set of challenges.
However, the underlying maths should not be one of them. I hope today’s post clarifies both the terminology and maths involved when people talk about cap rates.
In addition, you will have noticed that today’s post only touches on the financial aspect of calculating the cap rate, i.e. the mechanics of running the numbers.
Arguably, the far more important aspect is the commercial one. How do you know which numbers to plug into your calculation in the first place?
Incidentally, I am evaluating a deal at the moment that could serve as a good example of applying commercial logic to a real estate investment.
To the extent this is something you would like to read about, please let me know in the comments below and I will pencil in a separate post on the topic.
In the meantime, happy investing!
P.S: If there’s one book I would recommend on real estate investing, it is this one.
The author is both a proven real estate investor, an entrepreneur, and a professor at Columbia University with a specialization in real estate.
You can read my review of the book here (scroll down to Real Estate Investing)