When a group of people talk about their real estate investments, within the group there could often be may different types of investments discussed in the conversation. At some point everyone wants to compare each of their investments to the rest of the group’s investments others on an equal basis. More often than not, these individuals want to compare the returns on these different types of real estate investments to figure which investment returns the highest yield. In order to accomplish this, wouldn’t it be nice if there was a metric to compare these returns? That is where the cap rate calculation can be used.
The cap rate, or capitalization rate, is a calculation that can be used to compare different types of real estate investments. The cap rate is the annual net operating expenses, not including financing, divided by the value of the investment. You can look at the cap rate as the percentage return an investor would receive on an all cash purchase. For example if you owned a rental property that netted $850 a month after you collected the rent and subtracted the expenses such as: the management fee and monthly maintenance costs, and the property was worth $120,000, then cap rate on this investment would be $850 times 12 months divided by $120,000 = 8.5.
Now let’s look at a promissory note. Let’s say the note balance is $30,000 at an interest rate of 8% for a term of 12 years. The cap rate on the note would be the net income, $3,528, times 12 months divided by $30,000 = 11.7
As you can see even though the promissory note is a smaller financial investment, it has a lot larger cap rate for the investor.
Now you have a way to compare these two different investments returns against each other. Cap rates allow you to better understand different types of investments but they don’t always show the whole story. For more on that, tune in next month’s newsletter.
If you are interested in learning more about investing in promissory notes, contact us, we would love to talk.