What is a cap rate? A cap rate (or capitalization rate) is the net operating income divided by the price of a property. If you have a $100,000 property and its net operating income is $10,000 the cap rate for this property is 10%.
What does this mean to you? How have cap rates affected the current real estate boom?
If you pay cash for this property, your cash on cash return will be 10%. How does this tie in with interest rates? Simple math will tell you that if you can borrow money at 9% and buy property with a 10% cap that you have a 1% spread. The maximum return that you can get from a situation like this is infinite. The less you put down, the greater your return is (red line).
What if interest rates were at 10% and your cap rate was 10%? Well, then your return on this property will be 10% no matter how much you put down (blue line).
And what if interest rates are greater than cap rates? Well you will have a negative return until you put enough down to break even. If interest rates were at 11% and your cap rate was 10%, it would be around 10% down or $10,000 (green line). What’s interesting to note is that your return will never go above 10% no matter how much you put down.
Now you can see why there was a real estate boom in the past 5-6 years. Interest rates were below cap rates and investors could borrow as much as they wanted. In fact, the more they borrowed, the better their return. As more people jumped on the real estate bandwagon, prices went up and cap rates came down. Eventually the cap rates became lower than interest rates. From the chart, you can see that your cash on cash return is limited to the property’s cap rate if your interest rate is above it. So why were people still buying? The answer is potential appreciation. With real estate prices rising so fast, people were ignoring the fact the fundamentals did not make sense. They were content with a 3% cap rate and negative cashflow because of the appreciation potential.
And that was all fine and dandy until about 8 months ago. The appreciation train derailed and now they are stuck with these 3% cap properties and 9% investor loans. In times of no appreciation, we must stick to the fundamentals.