Move over, net yield: A new property calculation I'll be using

Last updated: 17 November 2017

Recently I've been researching investing in US property. Along the way, I've encountered the property equivalent of the eggplant/aubergine conundrum: lots of things in America sound exotic, but they've just chosen a completely different word for the same thing.

I've come up against fully amortizing loans (repayment mortgages), hard money lenders (bridging finance) and rehabs (refurbs). Then, just as I was ready to send my mental US/UK dictionary to print, I had to get to grips with something a big different: a calculation known as the cap rate.

At first, I thought the cap rate was just those crazy Americans coming up with a fancy new term for good old-fashioned yield. But it's actually something entirely new…and like many other great American inventions (like having pancakes for breakfast), I think it's time to import it.

If you're not familiar with the concepts of yield and ROI, this post will make a lot more sense after you've read my article on essential property calculations.

What does “cap rate” mean?

The cap rate is calculated by taking the rental income, deducting all non-mortgage expenses, then dividing this number by the purchase price of the property.

For example:

In UK terms, it's similar to net yield: but the difference is you don't deduct the mortgage payment. In other words, it tells you the return you'd make on an all-cash purchase.

Why is this useful?

I still maintain that ROI is the number that investors should ultimately be focused on: because this takes account of your mortgage too, it allows you to see what return you're actually making and compare it to the return you could make in other investments and different asset classes.

But where cap rate comes in handy is comparing different properties. Typically in the UK, we do this with gross yield: to keep things simple, we just divide the rent by the purchase price to get a very rough measure of how hard the property will make our money work. Getting into net yield and ROI is too fiddly, because mortgage payments will differ depending on what products are available and how creditworthy an individual borrower is.

The cap rate swerves the mortgage issue while still capturing the costs you'd associate with that property: the likely repairs, vacancy, management costs, insurance costs, bills, and so on.

This allows you to compare – for example – the cap rate delivered by a flat compared to a house, because the calculation will include the flat's service charge and the house's likely higher maintenance expenses. It also allows you to compare a single-let to an HMO, because the HMO's bills and higher management costs will be baked in.

Putting the cap rate to work

Where the cap rate could really come into its own is for sourcing agents presenting properties to potential investors. Showing the cap rate gives a realistic picture of returns after operating expenses have been accounted for, without the complicating factor that every investor would be using a mortgage product with a different monthly payment.

Because it's widely used in the US I've found it to be the most useful number in assessing different investments over there, and I might start using it as part of my UK analysis too. In retrospect it's obviously a good idea, but until looking to the US I'd never thought of it. Much like putting bacon on a pancake.