Understanding CAP rates
3. Understanding CAP rates, ROI and GRM (this section is math heavy)
A multi-unit property’s value is in large part due to how profitable it is. How profitable a property is, relevant to its cost, is called the “capitalization rate” or the CAP rate.
CAP rates are the net annual profit a property yields using the following formula:
Collected monthly rents X 12 months
Minus all (and I mean ALL) expenses for the year: vacancy, management, maintenance, taxes, insurance, utilities, legal services, advertisements, etc.
Divide that number by the total cash used to purchase and set up the property. (down payment + closing costs + rehabilitation costs)
The end result of that equation is your net annual profit / CAP rate.
CAP rate Example and Estimate: Given a tri-plex that cost $600,000 + $5,000 in non-recurring closing costs and $20,000 in needed repairs (a total cost of $625,000) and rents for $1,500 monthly per unit (x 3 units) $4,500 monthly rent x 12 months per year = $54,000
$54,000 “annual gross rent”. Now subtract from that…
-$2,700 (5% for vacancy, a reasonable expectation)
-$3,105 (6% management fee on collected rents)
-$2,250 (placement fee = 1 month rent every 2 years per unit (a reasonable estimate)
-$5,400 maintenance +/- depending on the age and condition of the property & quality of tenant
-$7,500 estimated annual property taxes
-$1,400 estimated annual insurance
-$3,500 annual utilities (this can vary depending on what you do or don’t pay vs. what tenant pays)
-$1,500 legal, advertising, miscellaneous +/-
-(27,355) subtracted from the annual gross rent =
=$26,645 net profit Now divide that by the total purchase cost of $625,000 = .0426 or 4.3% annual return or in industry terms, a 4.3% CAP rate.
If you managed the property yourself you would save the management and placement fees of $3,105 and $2,250 ($5,355 total) giving you a $33,960 net profit for a 5.43% annual return.
Bank loan costs and payments are not part of a CAP rate calculation but are critically important. If you have a CAP rate higher than the bank’s interest rate on the mortgage you will make a profit on that spread. If the bank’s interest rate on the mortgage is higher than the calculated CAP rate you will take a loss on that spread and should pass on buying that property or pay cash.
In the above scenario, if you can get a loan below 4.3% or 5.4% if self-managing OK, if not you should pay cash for such a property. Better still, let me help you find you a property that makes a higher profit!
“ROI” and Cash on Cash, another real estate term. This is the actual Return On Investment (ROI) and is calculated including financing. Real profit can be improved by purchasing a rental with financing if and only if the CAP rate is higher than the mortgage rate.
A basic example would be if the above property were purchased with 25% down ($150,000 down + $5,000 in closing costs + $20,000 in needed repairs = $175,000 actual cash to close escrow) and 75% financed ($450,000 financed) at a 4% interest rate. If you purchased the above property with a 4.3% CAP and had a 4% interest loan the approximate scenario could be:
$600,000 purchase price
$150,000 down payment (25%) (leaving 75% or $450,000 financed at 4% gives you $2,148.37 monthly payments or $25,780.43 annually)
+$5,000 closing costs
+$20,000 needed repairs
+$175,000 Total Cash Invested
Your Net Annual Cash Income would be the gross rents $54,000 – expenses $27,355 = $26,645 – $25,780.43 bank payments = $864.51 Dividing that by your cash investment of $175,000 = .005 or .5% Cash on Cash return.
But that is not an accurate representation of your actual return on investment or ROI. Your ROI is the $864.51 + $7,925 (the amount of the first year’s payments that are principle pay down) = $8,789.51
$8,789.51 ÷ $175,000 total cash invested = .05 or 5% ROI
Again, real net profit can be improved by purchasing a rental with financing if and only if the CAP rate is higher than the mortgage rate.
The Gross Rent Multiplier or GRM is the asking price $600,000 ÷ gross scheduled rent $54,000 = 11.11 GRM (The lower this number, the better)
Disclaimer: The above scenarios are for education purposes only. Though I try to produce realistic examples, they are not an offer or exact. Also, a more accurate example would include additional vacancy if increasing rents, estimated reconditioning costs for each vacancy created and miscellaneous expenses such as occasional eviction costs all added to the annual expenses. Self-management could save on expenses but if you’re not experienced, take a class.
What to expect:
1) Single family homes usually produce 3% to 5% CAP Rates (+/-).
2) Duplexes, triplexes and fourplexes can offer a little higher CAP of 4% to 6% (+/-)
3) Multi-unit complexes of 5 to 400 rental units typically sell for 0% to 2.5% over the current 30 year amortized commercial property finance rate. This assumes they are priced fairly and not in an extreme buying or selling frenzy market. If current rates are 4.5%, CAP rates on these should be 4.5% to 7% (+/-).
4) Most of the time rents go up as the years pass and this improves the profits significantly. A 3% annual increase in rents and property value is a home run. In that scenario, after 10 years the gross rents would be $67,196. The ROI would then be 14.4% annually, and the total appreciation would be $210,000. Even a 2% annual average growth is great as the years pass.
5) In lower income neighborhoods with lower rents, expenses such as maintenance, vacancy and management are often higher as a percentage of the rent. This is partially due to additional tenant turn over and fixed expenses.
6) Properties in higher income neighborhoods statistically sell with lower CAP rates because although less profitable they are considered more prestigious and more stable.
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