Q: What do Rental Ranking cap rates mean for my investment?

Does your 6.25% cap rate for Salt Lake City reflect single-family dwellings or multi-family?  Would you provide some examples? 

Thank you for writing! For the benefit of other readers, you are referring to the cap rate for the Salt Lake City metropolitan area that we published in our exclusive Rental Rankings. And yes, we just published our Q2 numbers for 2014. 

The AllPropertyManagement.com Rental Ranking system actually combines data from a number of different sources, including the Census Bureau, CoreLogic, the Department of Housing and Urban Development, the Bureau of Labor Statistics and (when we need to), reporting from CNN Money.

We compile these statistics for the nation’s 75 largest metropolitan areas: 

• Vacancy rate
• Capitalization rate
• Annual rent increase
• Appreciation
• Job growth

We rank each category in order of favorability for the investor, and then average the rankings to come up with the Rental Ranking score. List each city in order of its ranking – or divide them according to the broad geographic region – and you have our exclusive Rental Rankings!

Boiling things down to your specific questions: Our capitalization rate numbers reflect data from single-family homes, rather than multi-family. We get the average rental yield figures from the Department of Housing and Urban Development, and divide them by average home prices, which we get from CoreLogic, a leading real estate data and analysis firm.

We aren’t directly surveying individual properties – we let the Department of Housing and Urban Development handle that – so the data comes to us already aggregated. So there’s not one single property we can pull from our own data to illustrate how it works. But there is some published information we can work with. 

First, to keep the math easy, let’s take a hypothetical example: You have an opportunity to purchase Wasatch Manor, a 12-unit property with 10 units currently rented at $1,000 per month, each. So the property is currently generating $120,000 in rental income each year. 

The seller would like to sell it to you for $1.2 million. 

That very simple example generates a capitalization rate of 10 percent ($120,000 / 1.2 million)

Of course, we’re leaving out a lot of expenses that you, as the investor, are going to have to figure out for yourself: Interest, taxes, insurance, management fees, maintenance, reserves, marketing, and a budget for capital improvements. You’ll also get the benefit of depreciation deductions, as well, since the property is an investment property (provided you don’t hold them in a retirement account.)

For that reason, real estate investors use a somewhat more complicated formula to determine capitalization rate: The net operating income divided by the sales price. 

The net operating income is the actual cash yield the investor can take out of the property each year – after expenses. So that 10 percent figure you get just dividing rent receipts by the sales price is pretty meaningless. You have to look deeper under the hood. And if someone tells you they are selling a property at a certain cap rate, it’s important for you to look at how they determined that net operating income. Figure it out for yourself. We publish an aggregate, which is useful for making broad comparisons from one city to another, but you have to be more exacting when looking at an individual property. After all, anyone can temporarily inflate their cap rate by skimping on repairs and maintenance for a couple of years!

This doesn’t mean the cap rate is useless – it’s vital, provided it’s honestly calculated with real world expenses factored in. The fatter your cap rate number, the more cushion you have against guessing wrong on your other estimates – a vital consideration that Warren Buffett and his mentor, the late Benjamin Graham – describe as the margin of safety.

Hope that helps, and thanks, as always, for writing!