cap rate??

Question

whats cap rate? is it important? whats a good percentage?

Jon Hill · Answer

Hello Andrew,

I do not have a specific commercial property investment that I am considering at this time.

Yet, could you please list the 5 steps that you use to determine if the deal is good or not?

Thank you,

Jon

A F · Answer

Once you understand how to calculate a cap rate (NOI/Purchase price) then you need to understand the purpose of a cap rate.

A cap rate is a snap shot view of the anticipated first year performance of the property regardless of financing and tax implecations.

It is only one method for determining the value of a stabilized investment.  It is not a good tool for measuring a value adding investment or an underperforming investment.

When completing a pro forma I use a cap rate for acquisition and one for disposition.  Ultimately it is only step 2 of about 5 for determing if an investment is feasible.  Let me know if you have detailed questions on a specific investment.

Jon Holdman · Answer

I have looked at actual numbers on some properties.  Not owners tax forms, though that is a good idea, but the details from the property manager.

I don't think you're likely to get a very good accounting unless you're talking about a large property that is professionally managed.  The info you get from the owner of a single SFR rental isn't likely to reflect reality.  For one thing, many expenses, like replacing a roof, evicting a tenant or having major repairs after that eviction, are very sporadic.  Just because there were none in the last 10 years doesn't mean you won't have one tomorrow.  Other times, the accounting is just not very careful.  Small jobs or services get done by the owner or paid for by the owner and not recorded.  Or, they get deliberately omitted in a listing to make the property look better.

Cap rates are commonly used for commercial transactions, not so much for SFR.  If you look at multiple listings in the same area, you'll start to note the aggregrate set of expenses that appear on all the listings, and note that almost all of them omit one or two items.

If you use the rule of thumb that expenses are 50% of gross rents, then cap rate becomes really easy to calculate:

cap rate = rent/2/purchase price

Even if expenses are different than that, and I don't think they will be much different for an apartment building, then they're very likely to be comparable for similar properties in the same location.  So, you have a basis for comparison.

Jon

Joshua Davis · Answer

Cap Rate is a measure of the ratio between the cash flow produced by a property and its capital cost (the original price paid to own the asset) or alternatively its current market value.

The rate is calculated in a simple fashion as follows:

annual cash flow / cost (or value) = Cap Rate 
For example, if a building is purchased for $1,000,000 and it produces $100,000 in positive net cash flow during one year, then:

$100,000 / $1,000,000 = 0.10 or 10% 
The properties Cap Rate is ten percent.

NOTE: Positive net cash flow = The amount left over after all fixed costs and variable costs are subtracted from gross lease income, however before debt service is subtracted.

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It is important in the fact that it allows you to look at each property in a simialr fashion.  However you must be certain that the Net Operating Income is calculated accurately.

What the cap rate represents is merely the projected return for one year  if the property were bought with all cash. Not many buy property for all cash, so you have to break the deal down, usually by trial and error, to find the cash on cash return on the actual investment using leverage (debt service).

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A good cap rate can be determined by your market cap rate, as well as your personal preferences on risk allowance vs return.

Josh

Jon Holdman · Answer

You're correct, Scott, cap rate is NOI/purchase price, not cash flow/purchase price.  Cash flow is often significantly less because cash flow = NOI - debt service.  Cap rate gives you an idea of how good or bad a deal is without considering your debt situation.

I think that's what Josh means, based on how he defines cash flow (i.e., it is before debt service.)  However, that's not the usual definition of cash flow.

Most cap rates quoted in listings are hogwash.  Expenses are commonly understated, inflating NOI and producing a higher cap rate than the property actually produces.

Cash-on-cash return is a different calculation.  Its cash flow / cash invested.  Since that does consider your financing, your own situation affects that calculation a lot.  But, in many ways, that's the more relevant calculation.

As far as "whats a good cap rate", that depends on what you want.  I've seen numerous listings that imply 6-8% is the "market cap rate".   If you consider the real expenses, not the understated ones used in the listing, its even lower.  Personally, I want much higher cap rates than I can get on CD's.

Jon

Manish Patel · Answer

Since we are knee deep in cap rate discussions I thought we could take it a little further.  Wheatie, you might enjoy this:

Cap Rate = NOI/Purchase price and you can solve for the value of a property by re-arranging the formula:

Value of property = NOI/Cap Rate

So what does this number even mean?  Well quite simply it is an unleveraged return for a property and it is usually calculated on based on an annual return.

So what does unleveraged mean?  Just that it is the return of money going in and money coming out assuming you paid for the property with all cash.  So what if you want a leveraged return?  Which you should if you are ever going to buy anything.  How do you calculate it?  Where he is a simple formula that almost nobody knows, but is very cool and I share it with my students:

Here we go:

Leveraged return =

Cap Rate - interest rate (market rate expected to pay)

multiply that by the ration of debt to equity (so if it is 75% it would be 3 to 1, or just 3)

add that back to the cap rate and you have your leveraged return

Example-

cap rate = 8%
interest rate = 6%
LTV Ratio = 75%

8-6=2%
2% X 3=6%
8%+6%=14% annual leveraged return

So now you have a leveraged number (back of the envelope), but who cares if you don't know what it means and how to apply it.  Without writing a book i'll say this, It is based on the RISK of the asset being purchased.  Speculative investments command higher returns - like development projects, where as stabilized properties require less.

Next time we can all have a blast talking about unleveraged and leveraged IRR's, Net vs Gross IRRs, and a bunch of other financial concepts.  I just don't know how excited people get about this stuff-I love it because when you truly can understand the math, you can truly structure a deal to maximize your return.

All the best everyone:)

Dominic Enea · Answer

I'm guessing market value, but it is definately NOI/value.

Here is how a typical real estate investment is evaluated.

Yield (or ROI)= Cap Rate + Growth Rate

This does not include leverage or tax implications.

But basically cap rate measures your immediate return while growth rate is a measure of appreciation.

We have seen cap rates fall significantly because the expected growth has increased.  As the market cools, the growth will not be expected to be as high which will cause cap rates to rise.

As this happens, prices will drop and rents will rise.

Dominic Enea
Coldwell Banker Commercial

C Chester · Answer

cap rate is NOI/MV(100)

Patrick Murray · Answer

What is MV?

Patrick Murray · Answer

You are absolutely correct about an owner using the schedule E to fudge the numbers. This schedule will not give an accurate NOI for several reasons and should be used as a good to build a proper income statement that can be used to evaluate the property. It is in the property owner's best interest to show a low net income for tax purposes, but if selling the property it will make the income seem lower than actuallity. I've had this happen before with a deal I was analyzing when the owner gave me their tax returns instead of an income statement.

cap rate??

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