The terms return on investment and capitalization rate get thrown around a lot in fancy-shmancy real estate circles. We’re going to demystify them.
Return on Investment (ROI) is a performance measure used to measure the efficiency of an investment. In other words;
How much money is this house making me?
It is used in many forms of business, but we will focus on how it applies to real estate.
ROI measures the return on an investment compared to the investment’s cost. To calculate this, the return on an investment is divided by its cost. The result is expressed as a percentage.
For real estate, it’s the income from a property minus costs.
There are many things to keep in mind when you see an ROI from a property, such as whether you are paying cash or financing, will you include closing costs, interest, and loan paydown. The ROI can look higher than it is when certain costs are being ignored.
When you see someone bragging about their ROI, take it with a grain of salt. They may not be accounting for all their costs.
Today, we are going to focus on a specific type or measure of ROI called a capitalization rate.
Capitalization Rate (Cap Rate)
If you are calculating the ROI on a real estate deal as if it was being done in cash, you are calculating the capitalization rate, often abbreviated as cap rate.
The reason cap rate is one of the most popular measures used in real estate is it allows you to compare investment opportunities to each other.
Sometimes ROI’s are calculated by using the down payment as part of the formula. This means the ROI can change based on the size of the down payment. This isn’t the case with cap rates. The formula for a cap rate has nothing to do with down payments or mortgages.
Ignoring financing and down payments, and just evaluating the deal as if it were a cash purchase lets you accurately compare one property to another. This is the brilliance of a cap rate. It makes comparing investments easy.
Here is the formula for a cap rate:
Capitalization rate = Net operating income / Acquisition price (ready to rent)
The acquisition price is the purchase price plus what it takes to get it ready to rent out. It may be move in ready or need extensive remodeling.
What is net operating income (NOI)?
Simple. It is the income generated by a property minus the expenses of operating the property.
You will see cap rates used often in real estate. When people talk about commercial real estate, or even multi-family real estate, they typically use cap rates as a way of showing how much income the property will produce. You’ll often see the cap rate advertised in the description of the property.
Cap rates are often used to calculate a commercial or multi-family property’s value. This may seem unfamiliar to people who are used to the way single-family homes are appraised, which is usually based on comparable sales (comps) in the neighborhood.
That doesn’t matter here. It’s the property’s ability to generate income that determines it’s value when it comes to multi-family and commercial properties.
You can find the value of a property by simply rewriting the cap rate formula to solve for property value:
Net operating income (NOI) / Cap rate = property value
If you know your NOI is $30,000 a year, and you know your cap rate is 10%
30,000 / .10 = $300,000 property value
The cap rate shows the potential rate of return on a real estate investment. The higher the rate of return, the better it is for the investor.
Keep in mind, you are subtracting operating expenses to find the net operating income (NOI), so that is really any expense that has something to do with operating the property. Some expenses are not operating expenses, such as:
- Tax savings
- Debt service (expenses regarding a mortgage on the property)
Keep in mind, we are only subtracting operating expenses because the cap rate gives you the percentage this asset will pay you as if it were a cash deal (no mortgage) and independent of tax savings. This is because these two things can vary from person to person and deal to deal. Cap rates are meant to be constant so you can compare properties based purely on their ability to earn income.
Let’s apply the cap rate formula to my first townhouse in D.C. It ended up not being a great investment financially, as we’ll see through this analysis.
Purchase price: $280,000
Now we calculate expenses. I’ve talked about the 50% rule in the past. If you want to calculate expenses quickly without screwing around too much, try this.
50% rule: Approximately 50% of your rental income goes to expenses
By the way, your mortgage is not included in that 50%. It still needs to come out of the 50% profit you make, hopefully leaving you a cash flow of some kind.
The rent on the property was $2200 a month.
$2200 x 12 months = $26,400 total rent
Applying the 50% rule means $13,200 in expenses, and $13,200 cash flow, before mortgage payment.
The formula for cap rate was net operating income / acquisition price
We get the net operating income by subtracting the expenses (using the 50% rule) from the gross operating income (total rents).
$26,400 total rents – $13,200 in expenses = $13,200 as net operating income (NOI).
$13,200 (NOI) / $280,000 (acquisition price) = 4.7% cap rate
It’s nothing to write home about. I didn’t know what a cap rate was when I bought this house, I was just buying a place to live!
This is low. Why is that? Am I a horrible investor?
Let’s try something else.
In my case, I don’t need to estimate using the 50% rule. I owned the property for 13 years and have lots of data.
Let’s use my actual expenses and see how close it comes to the 50% rule. We will then have a far more accurate capitalization rate. We can also see how close my real expenses come to being 50% of rents (the 50% rule).
Repairs and Maintenance
These two categories cover any expenses on things you do to the property to keep it in working order, outside of remodels or improvements that are expensive and add value to the property. That will be covered under capital expenditures.
This property was 20 years old when I bought it, and I just didn’t have too many problems with it.
$3,500 / year
These are expensive items that come up rarely. Good examples are replacing the roof, windows, or an A/C unit or heater.
If your house is newer, and you don’t anticipate these expenses in the near future based on your home inspection, you probably could budget about 5% of rents to this. I think 10% is a conservative amount for an older, single family home that will need things like this replaced in the foreseeable future.
$2000 / year
Try to get estimates from as many places as possible about vacancy rates in your area. You can try other landlords, realtors, property management companies, real estate investors, online resources, etc. If you can’t figure it out, estimate on the high side. This is true of all categories. Whenever you can’t get accurate info, go high on the estimate.
Better safe than sorry!
I have the data on my vacancy rate, so I’m not estimating. I never had the house empty more than a month, and renters changed out usually every two years. My vacancy rate was very low. I’ll say ½ month a year.
$1100 / year
This is straight-forward. You can usually look it up online. Every city has a different online resource and method to view this information.
Taxes were really high on this property. Almost the equivalent of two month’s rent!
$4000 / year
You can get this information from other landlords or real estate investors, or check with your own bank or financial institution.
$550 / year
When I bought the property, I think the HOA was $25 a month. It tripled in the time I owned it. Watch out, you never know what HOA’s will vote to do!
$600 / year
I managed the property myself. Some people will have another 7-10% of rents as an additional expense. Tenants pay all utilities.
Self managing in my opinion is easy to do with one property if you have an understanding tenant who knows you are doing it yourself and you’re an “amateur”. If you have more than one property, and you live in a different city, or like me, a different country, think about using a property management company. That’s what I do now!
These make up the major expenses. Let’s add them up.
Repairs and Maintenance $2500
Capital Expenditures $2000
Dividing the expenses by total rent will give us the percentage of our rents that are going to expenses. It will show us how accurate the 50% rule is.
Rent $2200/mo x 12 = $26,400 / $10,750 = 41%
So in my case, the 50% rule is a bit of an over-estimation. My actual expenses appear to be closer to 40%.
I self-managed, however, and that would add another expense that would be 7-10% of rents. That would bring it up closer to 45%.
Add Murphy’s law for crappy things that happen for no reason, and the 50% rule is a pretty good estimate.
So our expenses are $10,750 a year.
The property rents for $2200 X 12 months = $26,400
Total rents – operating expenses = net operating income (NOI)
$26,400 – $10,750 = $15,650 NOI
Remember, we are about to calculate the cap rate, or ROI as if it were a cash purchase. We are doing it this time using actual expenses instead of the 50% as a rough estimate.
NOI / acquisition price = Cap rate
$15,650 / $280,000 = 5.6% cap rate using actual expenses to calculate.
Earlier, using the 50% rule, we calculated the cap rate at 4.7%, which is pretty close.
You might see differing cap rates on similar properties due to a variance in operating income, expenses, and/or risk.
But there are other reasons as well. It is typical to see lower cap rates on properties that are in high cost of living (HCOL) areas, expensive neighborhoods, new construction, newer homes, and areas with good school districts and low crime.
This is because there is less risk associated with these investment. You have tenants that stay much longer, things break less because they are newer, and low crime and better schools makes for a desirable rental environment that keeps tenants in place.
What about an area where you would get a cap rate of 12% or higher?
It is likely this area that is more the opposite of what I described above. You probably are in older buildings, in a low cost of living (LCOL) area, poor schools, somewhere with higher crime and higher tenant turnover.
The capitalization rate is an estimate of what your percentage return would be in a cash deal. Most real estate is purchased with leverage (mortgages), so the ROI of the actual money invested, which is usually the down payment, ends up being higher than the cap rate. This is because leverage magnifies the returns or the losses.
In other words, by using a down payment of $20,000, you can control a property worth $100,000. If the house goes up in value, or if rents rise, those are calculated off the price of the entire house, and not just the down payment.
The brilliance of buying real estate with leverage!
So now you understand what a capitalization, or cap rate is.
So when do we calculate return on investment, or ROI, instead of cap rate?
When we want to calculate the return from just the money we are investing, and not take into account the entire purchase price.
But that story is best left for another article…
Leave your questions and comments.
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