Learn two very important metrics for income-producing investments, especial for multifamily and multi-unit properties.
- In this lecture, we're going to talk about a couple of concepts that really only apply to income producing assets. So rental properties would be one of them. These concepts, the yield and the cap rate, doesn't really apply to fix and flips 'cause it has to do with the income that a property produces. So let's look at what they are. Let's look at income properties first. So for an income property, it may look something like this where you invest a certain amount of money and then you collect some rent every year.
Hopefully they're growing, but in this example, let's just say every year you're collecting something consistent, okay. The yield of an income property is basically the rent in a given year divided by your total investment. So the yield can be different depending on which years the rent that you're using. The rent in year one may be a little bit lower than the rent in year seven. So when you are using yields to compare different rental income properties, make sure you're comparing them apples to apples by looking at say the very next year when they're stabilized.
Or when the first year when the occupancy of the unit is at its maximum occupancy or maximum expected occupancy. So whatever that may be. That may be at 90%, that may be 95%. It may be different depending on the property you're looking at, alright. Now let's look at the yield a little bit in greater detail. Let's look at two different investments. Let's say one rental income property will give you this amount of rents if you invest in it, and let's say a different rental income property gives you twice that.
So which is a better investment? Well, at the surface, it looks like the second one, right? Because you're getting twice the rents or twice the income from it. But you can't look at in that way. You have to look at how much you have to put in to make the investment in the first place. If both of them required the same amount investment, then yeah, the one on the right is giving you twice the returns. But what if the one on the right takes twice the amount of investment to get twice the returns? Well, in this case, they kind of look the same, right? Now what if it requires three times as much investment to get only twice the amount of return? That doesn't look as attractive any more, right? So the idea of a yield is that it allows you to compare income producing properties and allows you to look at them on an apples to apple basis because you can look at what the return of that income property is going to give you on a dollar for dollar basis in any given year.
So when you look at it in that way, you can compare income properties that maybe one requires twice the amount of investment, but it gives you a different amount of income. So you can compare them in this way with some other property that costs less to acquire, but it also gives you less rent. By looking at it on a dollar for dollar basis using the yield, you can now compare income property opportunities on an apples to apples basis. Now let's look at what happens if you bought property all cash.
And if you bought a property all cash, then your yield would actually equal to your capitalization rate 'cause the capitalization rate is also the NOI, but instead of dividing it by your total investment, it's now divided by the purchase price. The capitalization rate is associated with the purchase price. So if you bought it all cash, then your purchase price equals to your total investment so they're going to equal the same thing. But what if you bought it with debt? What if you took on 50% debt and then you only put half of it as an investment? Now, your yield is going to be different.
Your yield's going to be what's left of the NOI divided by your investment. Whereas the capitalization rate doesn't change. It's always going to be your NOI before any kind of debt divided by your purchase price. So what the capitalization rate tells you is something a little bit different. It kind of tells you information about how the market is looking at this property. So if you have something where the capitalization rate is really low, let's say like 5%, what it's saying is the purchase price is 20 times the income that the property is producing.
If the capitalization rate is 10%, then the purchase price is 10 times the income that it's producing. So what you end up having is the lower the capitalization rate, the higher the purchase price. And why would some properties have lower cap rates than others? Well, higher income producing assets, assets that are considered higher quality in better markets. So let's look at a rental income property. If rental income properties that are new, that are recently built, there's nothing to repair, nothing to maintain because it's brand new, and it's already leased up to somebody paying good rent in a market where most of the tenants or all of the tenants have jobs and have good credit scores, then those income properties are going to trade or sell at a lower cap rate or a higher price relative to its income because they're higher quality.
People are willing or investors are willing to pay for higher quality by paying a premium for those things. So things that have a higher premium will trade at a lower cap rate. So what are some properties that may trade at a higher cap rate? Well, let's say you are looking at an income producing property, but it's older. It requires renovation. It's in a place that tends to have people moving in and out a lot so you have higher vacancies. Well, when you have a property like that, investors should have less confidence that the income that its receiving, that they'd be able to consistently get that.
So to compensate for the risk, they're not going to be willing to pay as much for that income. So those kind of properties will trade at a higher cap rate where the purchase price is not many many more times higher than their income. So higher quality properties will trade at a lower cap rate. Lower quality properties will trade at a higher cap rate. Alright, let's look at this example. Let's say the purchase price of this investment at $100,000, and its NOI, its net income after everything is 10 grand a year, and that's what you get before you put any debt on it, okay.
But let's say if you were to invest with 50% debt, you borrow 50% of the purchase price from a lender, you put up only 50,000, then in that case, you get to keep $6,000 of the net operating income whereas 4,000 went to pay for the debt. Now I want you to calculate first, what is the yield on a cap rate if it was done all cash? This one's pretty straightforward, right? If it's done all cash, it's going to be the predebt NOI of 10K divided by 100 equal to 10%.
And the cap rate is the same thing, NOI over the purchase price. So it's 10 over 100, again 10%. So if you got it all cash, this is 10%. Well, now let's look at the other case now with the 50% leverage, right? With the 50% leveraged, now you're getting to keep six out of the 10, but you only put up 50. So now your yield on this investment with leverage is 12%. But what is the cap rate? Well you still bought it at $100,000 and it's pre-debt NOI. It's NOI before you factor in debt.
It's still 10,000, right? So your cap rate is 10%. That's what you paid for. So here I hope you can see that cap rate is not influenced by whether you take on debt or not, whereas your yield on your investment is influenced by whether and how much debt you actually take. So in this case we see that if you take on debt that is positive leverage, that actually helps you. It actually increases your yield or the return that you get on an annual basis for rental income property. So, that is the yield and cap rate.
And again, these are only relevant for income producing assets, because well, if you have no NOI, no income, it doesn't really make sense to look at these terms. It actually is quite useless to look at them. So while these only apply to the rental income properties, we've learned earlier that the internal rate of return and the cash multiples as well as the net present value can be used to evaluate all investments.
- Conducting market research
- The seven-stage investment process
- Due diligence: Validating and verifying your investment
- Financing and closing
- Exiting: Selling your investment
- Investment considerations and strategies
- Measuring returns
- How debt impacts your return
- Real estate analysis case studies