“Figures don’t Lie, but Liars Figure,” is attributed to Mark Twain, commenting that unscrupulous people twist facts to fraudulently present statistical data.
One of the areas where statistical facts are twisted in real estate investing is with the capitalization rate (cap rate).
As a result, we have compiled a list of key components to verify with a cap rate, especially when reviewing a proforma income statement.
Cap Rate Calculation
In simplest terms, a property’s net cap rate is calculated by dividing the annual net income (i.e., income after costs) by the total value of the property.
Net Cap Rate = Annual Net Income/Total Value
The problem lies in assigning correct numbers to this simple formula. “Fudging” the numbers in the formula, can make a potentially unprofitable property look profitable.
#1 Verify the Property’s Value using Recent Comps
Determining the value of a property is half the equation in determining the cap rate. So if the value is improperly assigned, the cap rate will be wrong.
Before purchasing investment property, review area comps to ensure that a reasonable value is assigned to the property, and that the value is correctly applied to the cap rate. As a result, then, you can have confidence in the cap rate when analyzing a property’s investment potential.
And since assigning applicable comps to a property is subjective, you may also find it helpful to set your own criteria for comps, which you can use when analyzing investment properties.
#2 Project Future Rents using Rental Rate History and Comps
On the income side of the cap rate equation, projected future rents must be determined for each property.
Overestimating future rents drastically distorts a property’s cap rate. For example, a property with rents overestimated by 10% raises the cap rate about 10%. And if the rents are overestimated by 15%, the cap rate is inflated by about 15%.
As a result, it’s very important to accurately project a property’s future rent based on rental history and comps.
#3 Include all Expenses When Calculating Net Income
The gross cap rate of a property only takes rents into consideration when calculating the annual income – it does not take expenses into account.
The net cap rate, also called the effective cap rate, takes rents and expenses (HOA fees, insurance, property taxes, vacancies, future repairs, property management, landscaping, utilities, etc.) into account to calculate the annual net income.
Since the net cap rate takes both rents and expenses into consideration, it’s sometimes call the “true cap rate”.
#4 Always use the Net Cap Rate
Always use the net cap rate when analyzing a property, because it includes all expenses to calculate the net income for a property.
Since expenses for a property can vary from city to city, and even from neighborhood to neighborhood, the net cap rate is a much better method of analysis than the gross cap rate.
Correct analysis of a property’s cap rate is essential to succeeding as a real estate investor.
Overestimating a property’s annual income by a few hundred dollars a month can drastically affect the net cap rate, and could be the difference between a health profit and an anemic profit.
Therefore, it’s important to verify a property’s value and projected future rents, using its history and the local comps. And by all means, only use the net cap rate when analyzing a property, while verifying the accuracy of all expenses.
Don’t be fooled by a phony cap rate!