Life lessons from Chubby (my dad) and other smart folks I’ve met on the road.
“Cap rate?” I asked. “What the heck is that?”
Chubby laughed. “Greg, it stands for capitalization rate. It’s a way to value rental real estate.”
“But Dad,” I said. “You once told me real estate values were determined by comparing sales of similar properties.”
“That’s true with homes,” Dad answered. “But with apartment buildings, office buildings, and other income producing properties, cap rate is more commonly used.”
“Can you explain?” I asked.
“Greg, suppose you are choosing between an older apartment building in a high-crime area or a newer building in a nicer area. You would certainly want a higher return on your investment as an incentive to buy the older building. That means the price would have to be lower or the rent higher.”
Dad could see the perplexed look on my face. He continued,
“Presume that each building generated the same $20,000 a year in rental income. You might be willing to pay $200,000 (10% return) for the newer building but only $100,000 (20% return) for the older building. Those percentages are cap rates – the return you demand based on the desirability and risk associated with the property. As you can see, when the cap rate goes up, the property value goes down.”
What did I learn from Chubby that day?
Capitalization rate is the percentage return buyers expect based on the desirability of the investment…. a lower return on nicer properties, a higher return on less desirable properties.
To determine the value of a property, divide this percentage (i.e.10%) into the annual net rent of the building (i.e. $20,000) to arrive at market value (i.e. $200,000).
Don’t feel bad if you have to read this again.
