The term “cap rate” is often used in discussions of real estate investing. Do you know what it means?
Cap rate is short for capitalization rate, which is defined as the rate at which your capital is returned to you by the income from a real estate investment.
For example, if you purchase a property valued at $100,000 and it produces (after expenses) $10,000 in yearly income, its return on investment (or cap rate) is 10%.
Note that expenses are items such taxes, insurance, maintenance, repair, improvements, and utilities if paid by the owner. It does not take financing into account. In other words, your cap rate in this example would be 10% whether you financed 80% of the purchase price or paid cash for the entire investment. Other terms, including cash-on-cash return and internal rate of return, help characterize returns when factoring in financing or leverage on an investment.
It seems logical to aim for as high a cap rate as possible. However, there may be variables which would make a lower cap rate investment more attractive…for example, if you have an opportunity at a 12% cap yet you know that there is extensive deferred maintenance, or perhaps the property is in a questionable area, the 12% return may not be as attractive to you. Conversely, an investment at an 8% cap that is newer construction in a better area may not return as much in the short term, but would likely hold its value better over time as well as require fewer capital improvement dollars in the form of upgrades.
A recent buzzword in real estate investing is “cap rate compression”. This is what happens in a hot market, when prices get bid up to the point that the cap rates diminish (a larger purchase price chasing a stagnant return – because simply paying more for a property does not increase its value to a tenant). Institutional investors with very deep pockets (insurance companies, pension funds) may not care as much whether their return is a 7% cap or a 4% cap; they simply want their money parked in an investment they consider stable. This can make things more challenging for smaller investors in the sense that it may be harder to find deals that meet one’s investment criteria. Does cap rate apply to other investments? Yes, it certainly can, even though it is primarily discussed in the real estate space. In theory, it can describe any investment with a positive cash flow.
Note that an investment that is expected to appreciate, yet does not produce cash flow, would have a cap rate of zero.
Does cap rate apply to how we invest our time and resources other than money?
The answer is no, because there is no universally applicable method of quantifying our time and non-economic resources. Regardless, if you have ever felt a qualitative mismatch between the investment of your time and energy in a project and the benefits you derive from the project, you may consider re-evaluating the allocation of your resources.
As you consider this, remember that investing for cash flow and residual income is better than speculating and investing for gains.
Until next time,
Dr. Lee Newton
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