A Kids Story About Understanding Bellingham Rental Cap Rates
One morning a couple years ago, I was in the kitchen making breakfast and Jazzy, my now-11-year-old daughter, was sitting at the table when she asked this question:
"Dad, when someone sells a house, how much of that money do they get to keep?
"I don't think I sprayed my sip of coffee, but I may have.
"Jazzy, that is an amazingly good question," I said.
Breakfast was put on hold and I'm certain we spent the next 10 or 15 minutes sketching out a hypothetical sale and the resulting "net proceeds sheet" as my fatherly pride beamed and my inner real-world-math-nerd's heart was completely full.
For me, that was peak living: getting to teach one of my favorite parts of my work with my girl.
I meaningfully indulge in real-world math almost daily across a range of categories.
It is especially validating, too, because I was one of those kids who fell behind in Ms. Elliot's 7th-grade algebra class and never again caught up.
I was indifferent because none of it was "real" to me; Ms. Elliot didn't tie the confusing subject to life in any way.
Jazzy's question, though, about a seller's net proceeds after a sale: REAL WORLD for regular people young and old, and easy to learn.
Today, I'm going to teach another real-world real estate calculation that should be understood by:
Every property owner, including owner-occupants and landlords/investors
Every tenant
Every business owner
Every public official who is involved in housing policy
...and it is simple enough for every child who has learned basic arithmetic.
In fact, I’ll share it in the form of a children’s story, with animals doing the investing.
Let’s also include a downloadable worksheet so you can easily do this exercise with your kids or grandkids, using your own house as an example.
Talking to kids early and often about money is a proven way to avoid it being taboo or wildly misunderstood later in life.
And learning this basic calculation is a great way to learn how math is part of everything around us.
The animal investors find a property
Once upon a time, there was a group of animal friends who had saved up some money and wanted to invest in a rental property.
They had their sights set on a cottage in the forest that looked to be in good condition, was in a great location, and it had a track record of good rental income.
The rabbit, however, was not yet convinced, and as rabbits often do, she asked, “How do we really know if it’s a good investment?”
It was a fair question, the others agreed.
The songbird chirped, “How can we evaluate the cottage’s financial performance, to make sure we are making a good decision?”
That's when their friend the wise owl came along, heard what they were up to, and offered to teach them about "cap rate".
The owl explained that cap rate is a simple mathematical formula, but it works like a special pair of glasses that helps investors see if a property is worth their money.
“Just like how glasses help you see things more clearly,” the owl said, “cap rate helps investors compare the price they must pay for a property against the amount of money the property will actually make.”
The animal investors did a little dance as they chanted, “Teach us how cap rate works! Teach us! Teach us!”
“OK,” the owl said. “Cap rate stands for capitalization rate. When something is fully “capitalized” that means it’s paid for.”
The animal investors smiled and nodded.
"So the cap rate," continued the owl, "tells us how long an investment will take to become fully capitalized, or fully paid for, by the money it makes."
The animal investors swooned; their friend the wise old owl was just so...
wise!
"Let’s use this cottage you’re all excited about as our example," the owl said. "How much can you buy it for?”
The bear pulled the flier from his fur and said, “We can get it for $500,000.”
“OK, great,” said the owl. “And do you know how much rent it earns?”
The bear studied the flier and then answered, “It says gross rents are $3000 a month, or $36,000 per year.”
All the animal investors shouted in unison, “Is that good? Is that good? Mr. Owl… is that a good cap rate? Should we buy it?”
The owl, who remained composed, quietly said, “We still need more information before we can calculate the cap rate.”
“What else do we need?” the tiger asked.
“We need to know the property’s operating expenses,” said the owl. “Those are the costs that you, the animal investors, will have to pay throughout a year to own and operate the property. The operating expenses should be reported on the flier.”
The animal investors all nodded their heads, and looked to the bear who held the flier.
“Here it is! Here’s the list of operating expenses,” growled the bear.
“Great!” said the owl, “Read them off to us.”
The bear shared the following:
Property taxes: $3500
Hazard Insurance: $900
Repairs and maintenance: $500
Water/Sewer/Garbage: $2200
“That’s it,” said the bear.
The owl wrote those down, and then said to no one in particular, “Those are only some of the normal operating expenses that would fit into a complete cap rate calculation. Let’s be sure there is nothing else.”
The bear, reading from the flier, then shared that the cottage was owner-managed, so there were no fees for property management.
He shared that they reported no vacancy in recent years, so there was no lost income from the cottage sitting empty.
The seller hadn’t needed to spend any money on marketing, since there were always animals waiting to move right into the cottage whenever a tenant moved out.
There were no attorney’s fees to account for, since no legal matters had arisen.
And the tenant had been paying for their own electricity, natural gas, and landscape maintenance, so none of those were expenses for the investor/landlords.
“Seems like you've written down all the operating expenses already,” the bear said to the owl.“Great,” said the owl. “So if we add those up, we have $7100 in annual operating expenses.”
"We are now going to subtract those from the gross rents of $36,000 and we arrive at a figure of $28,900.”
“That,” continued the owl, “is what is known as your NOI, or net operating income!”
The animal investors were shaking with excitement.
“What’s next? What’s next?” they cried to the owl.
“Now we just divide our NOI by the purchase price, and that, my dear friends, gives us our cap rate. That formula looks like this:$28,900 ÷ $500,000 = 0.0578“If we express it as a fraction,” the owl said, “we arrive at 5.78%!"
"THAT, animal investors," proclaimed the owl, "is your cap rate!”
"OK but hold on," said the cat, who until that moment had just been listening.
"Mr. Owl, we are planning to get a loan for this purchase.”
"We'll have mortgage payments," the cat continued.
"Don't those go into the "operating expenses" category?"
"That is a fantastic question," said the owl.
"But the answer is No. It doesn't matter if you buy a property with a loan, or pay cash."
"The cap rate is based only on the operating expenses and the purchase price."
"That's what makes it an "apples to apples" comparison of one rental to the next to the next, and truly allows all investors to use it as an objective analysis tool."
Hearing this news, the animal investors were completely unhinged. Several squealed in delight. Others hugged as they danced around and around.
Suddenly, though, they stopped. Together, they all turned to face the owl.
The bird broke the silence when she chirped, “OK, so we have our cap rate of 5.78%."
"But Mr. Owl… is that a GOOD cap rate?”
The wise old owl complimented the bird for asking the most important question, and then shared his wisdom:
“Cap rates can be calculated on individual properties, like what we just did,” explained the owl.
“And cap rates also generally define an entire market area, like this forest."
"If you watch all the rental property sales in the forest and track their cap rates at the time of sale, you’ll find that a reasonably tight pattern emerges.”
The rabbit, as rabbits often do, asked, “What is this forest’s average cap rate?”
“Cottages in this forest usually sell for a cap rate closer to 5%,” the owl answered.
“When we see a materially higher cap rate like this one, at 5.78%, you want to look at it verrrrrryyy closely to make sure there’s nothing big and scary and expensive to fix.”
“And what if we inspect it,” asked the tiger, “and also review the lease, and carefully verify the stated operating expenses, and it all checks out as A-OK?”
“Then the answer is simple,” said the owl.
“YOU BUY IT!”
The animal investors spent the next week getting the property under contract, then doing all their due diligence to make sure everything checked out.
They found the cottage's construction, the leases, and the financials in tip-top shape.
In talking to the seller’s Realtor, they learned that they had intentionally priced it at a high cap rate to achieve a quick sale, since there was a 16-unit beaver dam in a nearby river that the cottage-seller just had to have.
By saving up their money, watching the market closely, and because they humbly asked the wise old owl teach them how to evaluate the quality of the investment with a simple formula, the animal investors were successful in adding a great property to their portfolio!
It's your turn to calculate a cap rate!
Kids, if the animal investors can learn the importance of cap rate and how to calculate it, you can too!
Get your folks to provide you with a Cap Rate Worksheet by clicking this link, download the page, and print a copy.
Use your house as an example, and fill in the blanks on the worksheet to determine your cap rate!(You can use the price your folks paid for the house, or you can contact BNP Realtors for an updated market value!)The next time you drive across town, consider that every other housing unit you see is rented, and has a cap rate that helped the buyer make a buying decision, just like the animal investors.
As you age up and think about buying a property, you can use the cap rate formula to analyze its financial performance just like professional investors, and just like the animal investors.*I could write 100,000 more words on the subject and nuance of cap rates, not to mention the myriad other financial analysis tools investors use like:
Time value of money
Internal rate of return
Debt coverage ratio
Cash-on-cash return
And others
But this cap rate formula is a powerful, easy-to-understand metric used worldwide.
It stands up now, and it will stand up 100 years from now.
Some things never change
Our market, heck, the entire economy, has changed from a year ago, or even from 6 months ago.And it will continue to constantly change season in and season out.
These powerful math tools like cap rate, however, will remain constant through every market shift, in every corner of the world, forever.
Learning what they mean and acquiring the simple skill to quickly calculate them is EXACTLY what Kiyosaki means when he says, "Don't be average."
It would be an honor to help you or help your kiddos work through a cap rate exercise, so it becomes forever a part of your skill set.
You know how to reach me!
