If you have seen an advertisement for an investment property, chances are you have come across a term called a “Cap Rate.” Simply put, a Cap Rate is an annual return on a real estate investment without taking your loan payments into consideration. It is arguably one of the most common metrics that real estate investors use when evaluating a small (or large) real estate investment.
A very basic example of how a Cap Rate is calculated is as follows on a $1,300,000 Purchase of an Investment Property:
$100,000 Gross Rents Annually
($35,000) Expenses Annually
$65,000 Net Operating Income (Gross Rents Minus Annual Expenses)
5.0% Cap Rate (Net Operating Income/Purchase Price)
Seems easy enough, right? Be careful. One of the problems with evaluating a multifamily investment strictly on Cap Rate is that Cap Rates can be manipulated simply by manipulating expenses. Take the example above for instance – let’s say whoever is advertising this deal published “Utility” expenses that were $10,000 less than they actually were on an annual basis. That would make the annual expenses for this deal $45,000 (instead of $35,000) and thus make the Cap Rate 4.2% instead of 5.0%. By way of comparison, the “Price per Unit” metric cannot be manipulated – that is simply the purchase price divided by the number of units.
A common mistake that some folks make when calculating a Cap Rate (at least in LA) is not accounting for reassessed property taxes for the Buyer. A Buyer who is purchasing a property from a Seller who has owned the property for 30 years is going to pay vastly more property taxes than what the Seller was paying – because in LA County, property taxes are assessed at roughly 1.25% of the Purchase Price upon sale. Property taxes can account for as much as 50% of a Buyer’s total annual expenses. So whatever amount the Seller was paying for property taxes is virtually meaningless to the Buyer. Some do not account for this adjustment and use the Seller’s current property taxes in their underwriting which can swing a Cap Rate astronomically and ultimately be very misleading.
While a Cap Rate is certainly an important metric, you should be wary of relying on the cap rate that is advertised.