Cap Rate vs. Return: What a Tired Landlord Should Really Measure

Cap rate is the wrong number for a tired landlord because it measures how a property is priced, not what it returns to the person who owns it. A better measure is return: what the property earns after your time and costs, how its value changes, and what you would keep after the tax owed to step back.

Listings, brokers, and spreadsheets commonly lead with a single income figure. It is useful for comparing one building against another, but it does not answer whether to keep owning one. For owners considering a way to step back, here is how an exchange with Flock Homes works.

What does return mean for a rental owner?

Return is what owning the property actually does for you each year. It includes the income the property produces, the change in its value, and the costs that come with owning it, including your own time. Income is the rent left after taxes, insurance, repairs, and vacancy, also called net operating income. The change in value depends on the market and varies from year to year.

Why doesn't cap rate show what your rental really earns you?

Cap rate, short for capitalization rate, shows only one piece of return. It is net operating income divided by the property's value, and investors use it to price buildings and compare them with each other. That is why a lower cap rate usually means a more expensive property, not a worse one. It counts one year of income, and it treats the owner's time as free, including the 2 a.m. call about a burst pipe that can't wait until morning.

What happens to your return once you price your time?

Putting a price on your time lowers your return. The illustrative example below uses round numbers and looks at the return from rent each year, before any change in the home's value. Once the owner's time is counted, it falls from 6% to 4.8%, even though the home itself is worth the same.

Start with a house worth $500,000:

Now count the owner's time. Assume 10 hours a month on showings, rent collection, and repair calls, valued at $50 an hour:

If an owner hires a manager instead at 10% of the rent, that is $4,800 a year, which leaves $25,200, a return of about 5%. Property management fees vary in what they cover, so the 10% figure is one assumption among several. These figures describe a typical year.

What else affects your return?

Concentration, stress, and the tax owed on a sale all affect your return.

Concentration comes from owning one house, which means one tenant, one roof, one furnace, and one local market. On the $500,000 house above, a $15,000 roof is half a year's net operating income, and it arrives as a single bill. A diversified portfolio spreads that exposure across many homes.

Stress comes with the job. A water heater that fails on a holiday weekend, a tenant locked out late at night, or a leak that spreads while you are on vacation can't wait for a convenient time, and for a self-managing owner, those calls come straight to you. Josh ran rentals across four states for over 20 years. "My rentals were profitable, but I just felt like I was constantly underneath them." A return figure can capture the profit, but not the strain. Another landlord's story, the quiet burnout, describes a similar situation.

The tax owed on a sale can take the largest bite out of your return. When a rental is sold, these federal and state taxes can come into play:

• Long-term capital gains tax: 0%, 15%, or 20% of the gain, depending on your income.
• Depreciation recapture: up to 25% on the part of the gain that came from depreciation you claimed.
• Net investment income tax (an added tax on investment income for higher earners): an extra 3.8% if your income is over $200,000 (single) or $250,000 (married filing jointly).
• State income tax: varies by state, and some states have none.

The following illustrative example uses the 15% rate. Assume the house was purchased 10 years ago for $300,000, and $275,000 of that was the building. The building depreciates over 27.5 years, which works out to $10,000 a year, so after 10 years the owner has claimed $100,000 of depreciation.

That's $55,000 in federal tax, nearly two years of the property's net operating income in this example, and it comes before the 3.8% tax, state tax, and selling costs. Talk to your tax advisor about your own numbers.

For an owner weighing whether to leave, the tax on a sale can be the deciding cost.

What should I look at instead?

Three comparisons give a fuller picture of your return, and none of them require special tools:

• Your return after the cost of your time.
• What you would keep after tax if you sold.
• Whether you would choose this house, at this price, with this much effort, if you did not already own it.

For owners who enjoy the work, or who already have a manager they trust, the numbers may favor keeping the property. These comparisons mainly apply to landlords weighing whether the effort is worthwhile.

Is a 721 exchange a good alternative?

A 721 exchange is an alternative to selling for owners who want to step back from management while keeping their equity invested. In a 721 exchange, you exchange the property for units in Flock's Fund instead of selling it, so the tax is deferred, not erased. In return you hold equity in a diversified portfolio of homes, receive quarterly cash flow (a set percentage of your account paid out each quarter) as cash or reinvested, and professional property managers handle the day-to-day running of the houses, including the calls that can't wait. The Fund aims to track the long-term performance of US housing over decades and targets an 8 to 10% total return. Total return combines the Fund's net income with the change in the value of its homes. Returns can move from year to year, so the target is a goal rather than a guarantee.

What is your rental really earning?

Once your time is counted, a self-managed rental often earns less than it first appears, and selling it can cost more than expected. Submit your rental address for a free valuation and see how your equity could work in a professionally managed portfolio instead. The valuation carries no obligation, and because Flock Homes keeps adding markets, our team will reach out either way.