What the %#&^ is a “cap rate”?

Can’t remember what a “cap rate” is? Put simply, it’s the return you get on a building in one year, ignoring the financing.

To calculate a return, you need to know how much profit you get in one year in exchange for investing a certain amount of money. So, for example, if you invest $1,000,000 and get $100,000 in the first year, you got a 10% return ($100,000 / $1,000,000 = 10%).

“Cap rate” is just the real estate lingo for “return”. So, if you buy a building for $1,000,000 and it earns you $100,000 in net operating profit in the first year, you bought a “10 cap”. If it only earned you $50,000, you bought a “5 cap”.

Remember that cap rate ignores financing… which makes sense. After all, cap rate is a method for evaluating the relationship between a building’s price and the profit it generates. By ignoring financing (which is different for every building and every buyer), cap rates allow you compare different buildings to figure out which is a better or worse deal.

Remember there is rarely a free lunch. The higher the cap rate (or, put another way, the lower the price relative to the profit), the riskier the property is likely to be. For example, in Beverly Hills right now, it’s very difficult to buy anything at better than a 5.5 cap. In South Central, you can buy 8 caps all over the place.

Why the difference? Because everyone knows that Beverly Hills is a safe place to own real estate, and many investors are unwilling to own assets in South Central at almost any price.

If you have questions about any of the math above, please just ask via a comment and I’ll respond. Or, if you’re shy, email me (moses@betterdwellings.com).