Cap Rates And The Stories They Tell
Cap Rate: The Number with a Story
If you and another investor buy similar multifamily properties, they both generate $1000 in revenue/ month, would you both make the same net profit? Not necessarily, it depends on your financing, or the payment terms under which you purchased your multifamily investment, and the resulting mortgage payment.
Financing real estate can be done in many ways with varying interest rates, loan durations, loan-to-value ratios and the list goes on. Depending on the terms of your financing your monthly mortgage payment could be $0 or >$1000. Imagine your mortgage payment is $100 but the other investor's payment is $500.
You're making $900/ month while he/she is only making $500. If such similar deals can generate vastly different profits, how do you compare them objectively? The short answer is a Capitalization rate, more often referred to as a "Cap Rate".
What is a cap rate in real estate?
So what exactly is a cap rate and why is it so important? Cap rates attempt to equalize all investments by removing the variable of financing. It assumes purchases are made all cash so all investors have the same mortgage payment - a whopping $0.
Once expenses are paid, there is no additional mortgage payment. All that is left is the net operating income (NOI) that the property generates. NOI is the Net Total income - total expenses. NOI is how much profit your multifamily apartment community makes before mortgage payments are accounted for.
The Cap rate formula is Cap Rate = Net Operating Income (NOI)/ Purchase price.
"Example: If you purchase a property for $10,000 and the NOI is $1000 the cap rate is .10 or 10%
10% cap rate = $1,000 NOI/ $10,000 purchase price "