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REAL ESTATE Understanding Cap Rates

JScott

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randallg99

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This might only be useful for the less experienced investors, but I just wrote an article about Cap Rates and thought I'd post it here for anyone who may be interested:

http://www.threetypes.com/re/cap-rates.shtml

Any feedback welcome...
great link...

only thing I can think of adding/emphasizing: slightly increase the assumptions for costs of ownership to create a more conservative and realistic outlook (and to ensure more profitable) that can withstand gyrations in the markets
 

yveskleinsky

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Great article! ...I struggle with an accurate application of a cap rate. Am I understanding the application right, in that the higher the cap rate the higher ROI? How much weight do you give to a cap rate- and should I call an appraiser to get the going cap in an area?

Thanks!

++rep
 
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JScott

JScott

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In general, the higher the cap rate, the higher the ROI will be. The reason for this is that the cap rate is inversely proportional to the price of the property -- the higher the cap rate, the lower the price that the property will be. And as the price of a property goes down, the ROI should go up.

Here's an example...

Imagine a property with an NOI of $100,000:

Case #1: You buy this property with a cap rate of 10%. Based on the formula (Price = Cap / NOI), the price would be $1M. If you put down 20% ($200K) and financed the rest at 7%, your annual cash flow would be $36K and your cash ROI would be 18% ($36K/$200K).

Cash #2: You buy this property with a cap rate of 12.5%. Based on the formula (Price = Cap / NOI), the price would be $800K. If you put down 20% ($160K) and financed the rest at 7%, your annual cash flow would be $49K and your cash ROI would be 30% ($49K/$160K).

So, yes, the cap rate is proportional to the ROI (as the cap rate increases, the ROI increases), though the cap rate generally won't equal the ROI (remember, ROI will generally be higher because of leverage).

As for how much weight to give Cap Rates, I would equate Cap Rates for apartments to comps for single family homes. A local area will generally have consistent cap rates for their multi-unit properties (at least for similar multi-unit properties), and if you find a property that falls outside the typical range within an area, you should ask "why?"

As for finding what typical cap rates are in an area, my suggestions would be to talk to property management companies (who manage properties like the ones you're looking at) or even just look at loopnet.com to get an idea of what things are being listed for.

Hope that helps!
 

yveskleinsky

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Thanks for the clarity! So, if I wanted to determine a FMV for a property, I could use Cap Rate as quick rule of thumb to see what a ballpark offer price might be? If I know that the going Cap is let's say 9% for office buildings in a certain area, and I run the numbers on the porperty I'm looking at and it comes out to a 7.5% Cap, I could write my offer based on a 10% Cap and use that as justification? ...Do appraisers and lenders go off of Cap to determine FMV for commercial?

Also, does the length of a mortgage term factor in? What about two mortgages/debt service amounts that are due at different times?

Thank you for your time! :notworthy:
 
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JScott

JScott

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Absolutely should use cap rates to determine a ballpark price for a property (adjusted of course for property condition, location, etc). In fact, this is probably the single most important use for cap rates for buyers! I've heard of a number of buyers who will use cap rates to justify price (i.e., "Sorry, I need a x% cap rate on this, so I can't pay more than $y").

As for mortgage(s) factoring in, they have absolutely no bearing on the cap rates. That's the great thing about cap rates -- regardless of the buyer's financial situation, financing decisions, or down payment, the cap rate stays the same. The cap rate on a property is the same whether the buyer has an 800 credit score, a 50% down payment and a 30 year fixed financing or the buyer has a 400 credit score, no down payment, and 5 hard money loans to cover the debt.

Remember:

Cap Rate = NOI / Price

The NOI is calculated based on the income/expenses of the property *before* debt service is calculated in, and the Price is independent of the financing. So, the entire equation is independent of financing, down payments, etc.
 

yveskleinsky

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Yes, of course length of mortgage term doesn't matter when figuring a cap- what was I thinking?:smx4:

...I am having trouble verfying a Cap for this property that we have an offer in on. I have called several Realtors, and 2 appraisers. All of which say that this market is unique. I would agree that it is- mainly in that it is all mom and pop places with only 50% of income being accurately documented. So where does that leave me? The place that I have an offer in on should produce a Cap rate of 11-16%. Big difference there huh? lol. I am having to go based off of estimations of what I know I can a property to do. Is there a better way to be doing this?
 

SteveO

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Great article.

Cap rates are very sensitive to movement based on the NOI. The NOI can move easily with small changes in the income or expenses.

Locking yourself in to specific numbers for cap rates will tend to push some of the biggest opportunities out of the picture.

Let's say you are looking at a $1,000,000 purchase and the cap rate is 6%

Price - 1,000,000
Income - 160,000
Expenses - 100,000
NOI - 60,000
Cap Rate - 6%

The exercise for the readers is to verify the cap rate using JScott's article. :smxB:

I look for mismanagement in this formula. Someone that does not understand the basics of how to setup a property to collect stronger rents. There are a lot of reasons why this would be the case but it usually comes down to property presentation, marketing, and sales. Customer service can play a strong role as well but the previous mentioned items are easier to spot at a glance.

If the income can be raised 12.5% to 180,000, the property would now be an 8 cap. That may sound like a lot of money but there are a few places to look for it.

One major issue that will bite novice investors is that they setup their own pro forma in such a way that the real income loss is not projected. Someone may pass a rent roll to you that shows you may collect 200K per year if the property is full. The setup sheet may factor in an 8% vacancy rate based on the area vacancy rate. There is more to consider with other income loss as well. So, what may be presented as an 8 cap may actually be a 5 cap. Make sure that you verify all of the books in your due diligence.

Back to the income. The following are some of the possible areas to raise income:

- Higher than market vacancy
- Rents below market
- Poorly managed collections and eviction process
- Slow to get units "rent ready" and back on the market
- Slow to increase current residents up to market rents
- higher than market "move-in" specials

Someone can draw the line at a 7% cap rate and completely miss an opportunity. Also, stating minimum cap rates may lead someone down the path of progressing into worse areas to find what they want.

I don't state a cap rate to my agents. Sometimes I don't even look at the cap rate until I am well into the process. Cost per unit on comparable properties will keep some owners from selling on cap rates alone. I like to use the cost per unit as my base tool and then look at where I can get the cap rate to based on "MY" pro forma. The issue that comes into play is that I have to be right in my projections.

Cap rates that are frequently tossed around may not be correct. They ars so fluid and easily manipulated. If you do all the number crunching on actuals and try to get something at your target rate, you may be in for disappointment.
 

yveskleinsky

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Steve-

I like what you are doing as far as value plays, and I am trying to do something similiar but with different types of properties- but how do I do a value play if a Cap Rate seems to be nothing more than an urban legend to this area?! Would I just present the increase in NOI to the bank and then try to refi out?
 

SteveO

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I like what you are doing as far as value plays, and I am trying to do something similiar but with different types of properties- but how do I do a value play if a Cap Rate seems to be nothing more than an urban legend to this area?! Would I just present the increase in NOI to the bank and then try to refi out?
You will still need to be able to get the cap rate and the debt service coverage ratio (DSCR) to a point that the lender will accept. Temporary financing is sometimes the answer but don't let yourself get stuck in a situation where you can't improve to the point of permanent financing.

DSCR=NOI/Debt Service (annual mortgage payment)

A DSCR of 1.2 is typical. You might get down to 1 or lower on a higher interest loan. Some banks will want 1.25% and a higher number will make it easier to get great rates and terms.
 
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JScott

JScott

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Locking yourself in to specific numbers for cap rates will tend to push some of the biggest opportunities out of the picture.
That's funny...I actually ended my article with the sentence, "So, if the average Cap Rate in your area is 10%, you should be looking for at least a 10% Cap Rate for your property (barring other more complex situations and considerations)."

What you wrote is exactly what I meant by "barring other more complex situations and circumstances"...

In fact, I was going to follow this up with another article or two on that specific subject, but I think you covered it all... :)

Thanks Steve!
 

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SteveO

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You still need to follow up. It needs to go on your blog.
 

Stevenh

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I haven't had time to read through all of this, but two large items I didn't see in there that need to be considered when looking at cap rates are

1. The occupancy of the property. A 7% cap on a 100% occupied property and 7% cap on a 70% occupied property are two entirely different beasts. (This is assuming you are basing your cap on Year 1 Pro-Forma NOI)

2. Are the inplace rents at, above, or below market rates? These will also have a large effect on the validity of your cap-rate.

I'm sure there are plenty of other things to consider, but these two ones popped up immediately.

Cap rates that are frequently tossed around may not be correct. They ars so fluid and easily manipulated. If you do all the number crunching on actuals and try to get something at your target rate, you may be in for disappointment.
Quoted for truth! I have looked at countless deals where I have seen a broker's 8-cap turn into a sub 6-cap after I am done building my pro-forma.
 

SteveO

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I haven't had time to read through all of this, but two large items I didn't see in there that need to be considered when looking at cap rates are

1. The occupancy of the property. A 7% cap on a 100% occupied property and 7% cap on a 70% occupied property are two entirely different beasts. (This is assuming you are basing your cap on Year 1 Pro-Forma NOI)

2. Are the inplace rents at, above, or below market rates? These will also have a large effect on the validity of your cap-rate.

This is what I base my entire investment process on. The ability to raise income is key. The 2 points above are the primary ways of finding potential income increases.

A 7% cap is a 7% cap. The potential for changing the income is the opportunity. If the property is 100% occupied, there may be room for significant rent increases. If the property is 70% occupied in a location that is 94% occupied, The potential for income increase is huge!!!

The validity of your pro forma is the real statement that you are making here. It is a powerful statement.
 

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I am beginning to understand this cap rate stuff. OK, say you see a property advertised for sale at a certain cap rate , example 10%. At first blush the property has appeal and is in the right location. So far so good. How does the advertised cap rate figure into your analysis? Is that the point at which you start negotiating? Do you totally disregard thier cap rate and do fact finding to establish your own rate and negotiate from there? Thaks to all you guys for sharing your knowledge.

Greg
 

Stevenh

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A 7% cap is a 7% cap. The potential for changing the income is the opportunity. If the property is 100% occupied, there may be room for significant rent increases. If the property is 70% occupied in a location that is 94% occupied, The potential for income increase is huge!!!
Exactly; and this is why buying certain properties on a 5% cap can be a screaming deal while the property next door is overpriced at a 7% cap. Deals are rarely an apples to apples comparison. If you want to compare deals on a cap rate basis you can level the playing field a little bit by basing the cap rate on the stabilized NOI.
 

SteveO

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I am beginning to understand this cap rate stuff. OK, say you see a property advertised for sale at a certain cap rate , example 10%. At first blush the property has appeal and is in the right location. So far so good. How does the advertised cap rate figure into your analysis? Is that the point at which you start negotiating? Do you totally disregard thier cap rate and do fact finding to establish your own rate and negotiate from there?
This is a risky answer as it is possible to get yourself in trouble. Many people overestimate the income and underestimate the expenses. What is really important is that you can accurately estimate them.

The cap rate can be used as a negotiating tool. There are other items that you can use as well. The seller pro forma is not one of them.
 

andviv

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Great article. Rep++
SteveO, what was your experience when you started investing out of state in how to manage your property managers? I do recall you manage the first one yourself as you were local, but what about the others?
I think it would be great if you can post something about what to look for and how to screen for property managers.
What to ask if the properties are in the 20-50 units? 50-100? 100+?
 

camski

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Okay I am struggling with how to properly figure cap rates and some of the things mentioned here So let me list my property and details and if someone wouldnt mind give me the example of figuring cap rate NOI and such.
It is a commercial property that was in bad shape when I bought it. It is a 3 story 17,000 sq ft building that used to be an old hotel. The purchase price was $16,500. I put in $31, 000 of my own money and got a construction loan of $51,000 to renovate the 1st floor to make it 2 seperate commercial spaces ( The top two floors will be done in stages as time and money permits). I have renters that both signed 5 year leases starting aug 07 and total rents equal $1500 per month (this is a very small town inIN so rents are cheap here). My taxes are $2500 per year and my insurance is also $2500 per year. My overall mortgage payment is $752 per month. Not that any of this matters to the overall monthly numbers but it is in a registered historic district so I am getting a rehabilitation tax credit on my taxes this year that is going to prove to be huge. So overall my question is help me figure the cap rate, NOI and all that stuff and give me your overall opinion on how I did on this deal. This was my first real RE deal and I realize that it isnt your typical way to start in RE but there were other factors that got me into this deal that arent really relevant but would like your opinions.
 

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JScott

JScott

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Cap Rate = NOI / Price

So, first let's figure out the price/cost of the place:

You paid $16,500, and you put in another $82,000 (your money plus a loan). So, the total paid on the place was about $98,500.

Your NOI is your annual income minus your annual expenses:

Your annual income is 12 x $1500 = $18000.

You annual expenses include: taxes ($2500) and insurance ($2500). Are there any other expenses you'll be paying ongoing? Perhaps maintenance, any utilities, landscaping, advertising, management fees, etc? If so, add them in here. But, for now, you total annual expenses are listed as $5000.

So, your NOI = $18000 - $5000 = $13,000.

Finally:

Cap Rate = NOI / Price = $13,000 / $98,500 = .1319 = 13.2%
 

camski

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There really isnt any other expenses involved as my renters pay all the utilities and there really isnt anything else to speak of. So what would your overall analysis be of my first real estate deal?
 
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JScott

JScott

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There really isnt any other expenses involved as my renters pay all the utilities and there really isnt anything else to speak of. So what would your overall analysis be of my first real estate deal?
From a cap rate standpoint, not bad. Though, keep in mind that you should have generated the cap rate number *before* you made the purchase, as opposed to after you made the purchase and found the renters.

Additionally, you should be looking at other financial indicators, such as: cash-on-cash return, total return, cash flow, and perhaps your debt service ratio.

Plus, what is the likely future potential of the property? Are incomes likely to increase in your area (is population and job growth positive)? Are expenses likely to increase or decrease? What are typical cap rates for properties like yours? This will tell you whether you'll likely make more or less money on this property in the future, and also let you know how much you can likely sell it for down the road, assuming that's your goal.

Only after you know the full financial implications (both current and future) can you really assess if it's a good deal.

And most importantly, a good deal for someone else may not be a good deal for you. Does this fit into your plan?
 

camski

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From a cap rate standpoint, not bad. Though, keep in mind that you should have generated the cap rate number *before* you made the purchase, as opposed to after you made the purchase and found the renters.

Additionally, you should be looking at other financial indicators, such as: cash-on-cash return, total return, cash flow, and perhaps your debt service ratio.

Plus, what is the likely future potential of the property? Are incomes likely to increase in your area (is population and job growth positive)? Are expenses likely to increase or decrease? What are typical cap rates for properties like yours? This will tell you whether you'll likely make more or less money on this property in the future, and also let you know how much you can likely sell it for down the road, assuming that's your goal.

Only after you know the full financial implications (both current and future) can you really assess if it's a good deal.

And most importantly, a good deal for someone else may not be a good deal for you. Does this fit into your plan?
I actully have no plans to sell it in the immediate future. Right now it is generating about $350/month positive cash flow and like I said I really got a major tax benefit from the rehabilitation credit. My expenses will likely increase but I also have have the ability to create further apartment/rental units on the 2 and 3rd story. In addition to that I will possibly be making myself an aparment and moving in there while then renting out the house that I am currently living in. Overall I feel it was a good deal that I am making money off of right now and that I can translate into further earnings later, but I was curious as to what soem of you veterans might say about it.
 

I85

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"Important: You should keep in mind that the Cap Rate isn’t necessarily the amount a real-life investor will make on a property. Because Cap Rate assumes that an investor pays 100% up-front for a property, and because an actual investor rarely pays 100% up-front, the actual return will differ from the Cap Rate of the property. In many cases, the actual return will be higher than the Cap Rate (one advantage of leverage)."

I understand the theory/formula for cap rate, but I am still not understanding why it is an important number. If I were to pay 100% for a property I can see using that, but I won't be paying 100% up front. Why wouldn't I be more concerned with what MY ACTUAL returns will actually be, the way I want to put the deal together.

Is it just used to decide if you want to look further into all the numbers, or just pass on the deal right there?
 

eTyler19

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Wow that is some great information. I have a question though... Can the cap rate be applied to buying a business that isn't a rental unit. Say for example you were going to buy a liquor store. Does the same concept apply?

Thanks!
 
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JScott

JScott

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I understand the theory/formula for cap rate, but I am still not understanding why it is an important number. If I were to pay 100% for a property I can see using that, but I won't be paying 100% up front. Why wouldn't I be more concerned with what MY ACTUAL returns will actually be, the way I want to put the deal together.

Is it just used to decide if you want to look further into all the numbers, or just pass on the deal right there?
First, cap rate is certainly not the most important number to look at, especially for certain types of RE investing (for example, where you expect to do a lot of property rehab, in which case cap rate doesn't tell you a whole lot about the after-improved value of the property).

And yes, you will definitely be more concerned with your actual returns (cash on cash, total return, etc).

But, cap rate does have it's place. Here are a couple good ways to use it:

- As a Comparison: It allows you to evaluate a property compared to other similar properties in a the same area. If 20 unit buildings in good condition are typically selling for a 10% cap rate in your area, and you find a 20 unit building in good condition with a 7% cap rate, it's likely over-priced. Unless there is something exceptional about this building that warrants the lower cap rate, you'll probably want to negotiate the price down or pass on the property.

- To Estimate Price: In the example, above, you found a 20 unit building at a 7% cap rate in an area where typical cap rate is 10%. You can use this information to determine (or at least estimate) a fair price to offer for the property. Because Price = NOI / Cap Rate, you can substitute a 10% cap rate into the formula instead of a 7% cap rate, and come up with a reasonable estimate for the value of the property.

Does that make sense?
 
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JScott

JScott

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Wow that is some great information. I have a question though... Can the cap rate be applied to buying a business that isn't a rental unit. Say for example you were going to buy a liquor store. Does the same concept apply?
Yes, it certainly can be...

In fact, capitalization rate be used to value any income-producing asset, including businesses. This is especially true in situations where future income is expected to grow at a constant rate year-over-year. In this case, you can use the capitalization rate to convert a single year income into the estimate of the overall business value.

Keep in mind that cap rates and earnings multiples are interchangeable here. A 10% cap rate is equivalent to a 10x earnings multiple; a 20% cap rate is equivalent to a 5x earnings multiple.

So, if you business is expected to earn $100,000 next year, and you want to apply a 10% cap rate, the value of the business can be estimated at:

$100,000 / 10% = $1M

Using an earnings multiple (in this case, 10x) results in the same thing:

$100,000 x 10 = $1M

While cap rate is the best way to value a business that is growing at a constant rate, it's not great for valuating businesses that are growing a variable rate.

In these cases, you would prefer to use discount rates instead.

I believe there is another thread that talks about discount rates and their use for valuing a business...
 

eTyler19

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Yes, it certainly can be...

In fact, capitalization rate be used to value any income-producing asset, including businesses. This is especially true in situations where future income is expected to grow at a constant rate year-over-year. In this case, you can use the capitalization rate to convert a single year income into the estimate of the overall business value.

Keep in mind that cap rates and earnings multiples are interchangeable here. A 10% cap rate is equivalent to a 10x earnings multiple; a 20% cap rate is equivalent to a 5x earnings multiple.

So, if you business is expected to earn $100,000 next year, and you want to apply a 10% cap rate, the value of the business can be estimated at:

$100,000 / 10% = $1M

Using an earnings multiple (in this case, 10x) results in the same thing:

$100,000 x 10 = $1M

While cap rate is the best way to value a business that is growing at a constant rate, it's not great for valuating businesses that are growing a variable rate.

In these cases, you would prefer to use discount rates instead.

I believe there is another thread that talks about discount rates and their use for valuing a business...
Sorry that was way over my head. I havent got to business multiples yet in my book. :coffee:
 

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