Cap rates

The guide is correct - you do not take into account mortgage payments to calculate a cap rate. The idea is to calculate what an asset is yielding regardless of how it is financed. This is a yield on total invested capital.

If you do subtract Mortgage payments, the metric you calculate is called cash on cash yield, and it gives you the yield on your invested equity capital (downpayment).

The cap rate is a weighted average of mortgage rate and equity yield. So if you know two of these items, you can calculate the third.

The last question is tricky because typical cap rates are different for different geographies and types of properties, so you need to know the prevailing cap rate to know if an asset is “overpriced”. But yes, it is a pretty good way to compare prices, as well as real estate Vs. other types of investments.

Finally, cap rate does not provide the full picture of returns. You also want to have a view on expected appreciation (although it is unknowable since no one can know the future). Many places that have high cap rates (like 10%) have flat or falling property prices (for example, Detroit). Some other places with lower cap rates might appreciate fast (Miami). The worst possible scenario is a low cap rate with no appreciation or even price declines. This is the situation for much of new construction in Manhattan in the last few years: cap rates less than 3% combined with price declines at resale. The best scenario is a high cap rate and a high appreciation which is the scenario in some areas that have gentrified in Brooklyn. In terms of price appreciation, past performance is not indicative of future returns (but all else equal, a high cap rate is better for returns than a low one).

Thank you! That is super helpful. Would you say a cap rate of 2 or 3% is respectable for Manhattan coops below 110th/96th? Or is it impossible to generalize?

(Thinking all UES all UWS)

It is my opinion that the cap rate should be similar to the mortgage rate for most people to buy to live in for at least 10 years.

For this buyer, his purchase has has the housing cost protected against future inflation with the exception of the maintenance fee and/or property tax. If he is renting, the rent will be much higher 10 years later due to inflation.

Due to the increased rent, the CAP rate by using the original purchase price will also be improving 10 years later, so this will also give the buyer the price protection.

If the cap rate is much lower than the mortgage rate, then the purchase will not make economical sense unless a huge bet is placed on the three factors 1: the mortgage rate will come down quickly, 2: the rent will increase very fast, 3: a quick increase of price to make a short term profit.

Of course, real estate is very local, with respect to the location, the time, the price strata and the person.

Right now, with 7% mortgage interest rate, there is probably no 7% CAP apartments as most current owners are staying put in their current 3% mortgage interest rate. I guess with several years of trickling down, due to the increasing rent (inflation), and price decrease (some people have to sell) and also possibly some mortgage rate decrease, then the mortgage rate and CAP rate will be re-matched for the apartments listed in the market.

For most people who purchased with 3% CAP rate with 3% mortgage rate in 2020-2021, the buyer will be stuck in his current apartment due to the current 7% mortgage rate. The golden handcuffs are not too bad, similar to the rent stabilized apartments

For the super luxury apartments where nada has lived in and other very expensive Manhattan apartments often discussed in this forum, the cap rate is never making sense to begin with and the rent is not necessarily increasing with the inflation. This sort of apartments also have liquidity issues due to a very limited pool of buyers.

@Woodsidenyc - Interesting! Sounds like a good rule of thumb

Normally those coops trade at 3-3.5% interest rate (lower for large and fancy units). Right one could find one br or studio for up to 5% cap rate, especially if negotiate.

That is still below the mortgage rate, so not the most economic purchase, unless you hold one of the three assumptions woodsidenyc listed above.

+1 There are good reasons to buy just right now money doesn't seem to be one of them :)

If you include "expected appreciation" everything pencils.

It's hard to know if and how much since it's in the future