Why Don’t We Talk “Cap Rate” in Single-Family Residential Real Estate Investing?
joe, Mar 29, 2023
Pretty regularly, I will have a prospective real estate investor ask me about cap rate. They’ll want to know the Cap Rate on a particular property, or what a good Cap Rate is for the Austin area. Right away, I know they are coming to me from the world of commercial real estate and are probably new to the residential investment market. I know I’ll probably have to do a bit of educating to show them that cap rate has no use in the world of residential real estate. The reason: Repairs.
But first, what is Cap Rate and why does it matter? Capitalization rate, or Cap Rate, is a popular tool used by commercial real estate investors. It’s the ratio between the annualized net operating income (NOI) and the current fair market value (FMV) of that property. The calculation is simple:
CAP RATE = NOI/FMVx100
Since most commercial leases are triple-net, meaning the tenant bears the burden of most expenses, including most repairs, the landlord’s operating expenses tend to be pretty stable and predictable from year to year. This makes Cap Rate easy to calculate for individual properties, and makes it a decent, albeit very blunt tool for comparing those properties to one another.
Triple-net leases are not used in residential real estate. That makes the landlord, not the tenant, responsible for big ticket repairs. Since all single family residential homes have major systems that require expensive maintenance and repairs at some point, and since none of these can be reliably predicted from year-to-year, it’s impossible to know what the operating expenses will be for any given year. If you don’t know that number, you don’t know your NOI. If you don’t know that, you can’t calculate a Cap Rate.
There is a tool similar to Cap Rate that I use in the world of residential real estate investing: Rent Ratio. The calculation is quite similar:
RENT RATIO = RENTx12/FMVx100
Like Cap Rate, Rent Ratio is a blunt tool used to evaluate individual properties or compare properties within or between markets. Unlike Cap Rate, it does NOT take into account any expenses whatsoever. This is a huge variable that should be considered separately. If a property has an acceptable Rent Ratio, and seems worthy of additional scrutiny, you’ll want to look immediately into the age of the property and the overall condition of its major systems so you can get an idea of what future repairs might look like as a part of your total analysis.