When you make an investment you want to make as much money as possible. Ideally.
So you think you want a high cap rate because that means you make more money? Not necessarily!
First, let’s define a cap rate… it’s very easy.
Cap Rate Defined
In very simple terms, it is the income you receive from a property (in the first year) divided by your purchase price. To get a little more technical (stay with me), the income is defined as the rent received less normal operating expenses (BUT excluding the mortgage payment).
What about Appreciation?
So a cap rate ONLY represents the income… hm. The other key piece of your return is the appreciation. This is actually what drives a majority of the return in most real estate deals. (Appreciation is how much the value of the property goes up. i.e. you bought it for $1 million and now it’s worth $2 million so the property appreciated by $1 million)
It depends on your strategy. Sometimes income is all you need so you can buy a super safe and relatively passive investment that provides income.
However, many people that invest in real estate want to be compensated for the risk and work. An 8% cap rate deal (not a bad cap rate) may not cut it for some.
The real money is made when you can buy a property for a 5% cap rate, and increase the income by “adding value” (renovating apartments / redeveloping common areas / providing more amenities / etc.).
Why Not Appreciation Cap Rate?!
Since cap rates are only the income portion of the return equation, why not have the same metric but for appreciation? My theory is that since appreciation is unknown, no one wants to be caught having the wrong “appreciation cap rate”. An income cap rate is the only thing that is likely known over the course of the first year.
Cap Rates in Action!
The example below is a powerful example of how small changes in income can yield massive changes in value. If you purchase a property making $1,000 for $20,000, that is a 5% cap rate. You purchased the property based on the income it produces. So you essentially purchased a property for a 5% cap rate. And theoretically if you wanted to sell it, you could sell it for a 5% cap rate.
So if you increased the income by $500, which represents a 50% increase, the value of the property would also increase by 50% ($10,000!).
This value increases becomes even more significant when you account for leverage (which warrants another post entirely!).
You can see that the income of $1,000 per year is minimal to the $10,000 of appreciation. You would need 10 years of income to make up for that value increase.
A cap rate (or the income received relative to the purchase price) is only one very minor piece of the puzzle when considering the merits of a real estate deal!
Also FYI, cap rates are actually short for capitalization rates, but that’s too long for people to say.