Definition1
Net Operating Income / Purchase Price Where Net Operating Income: Gross Rental Income - Vacnancy/Credit Loss Reserve - Property Taxes - Property Insurance - Maintenance/Repairs - Common Utilities (if any) - Other Expenses (ex: license/HOA)
Interpretation
- Cap Rate formula does not include mortgage expenses. This formula focuses on the property alone, and assumes the property is bought for cash w/o leverage.
- High cap rate means the investment is more risky, low cap rate means an investment is less risky
Drives
Macro-level economics and demographics
- Positively influencers on price (e.g. SF real estate market) result in a lower cap rate and less risky investment
Micro-level market influences
- Property desirability rankings should be inversely correlated to cap rate (lower desirability / higher cap rate)
Type of property
- Retail v. Residence -> Residence is less sensitive to economic trends (e.g. retail can get hit hard by recession). Therefore, a residence should have a lower cap rate.
References
1.
Carson, C. Cap Rate Explained (And Why It Matters With Rental Properties). Coach carson at https://www.coachcarson.com/cap-rate/ (2018).