What is a “cap rate”? In Part I and II of Techniques to Speed Up Your Decision Making, we covered two basic measurements to quickly estimate value of an apartment property.
These two were:
We learned that Price Per Unit is the simplest to calculate but provides little investment insight because income is not accounted for. Gross Rent Multiplier is a step up because it incorporates the rental’s income but is also flawed since expenses are not taken into account.
What is Capitalization Rate?
In this article, we discuss the subject of Capitalization Rate, often referred as Cap Rate or just Cap. It is similar to GRM but can be more precise because it considers vacancy loss and operating expenses.
Cap Rate = Net Operating Income / Price
Net Operating Income (NOI) is the sum of all potential income less vacancy and operating expenses. NOI does not consider debt payments, depreciation, or capital improvements.
Calculating Cap Rate: An Example
A 10-unit apartment building is offered for sale at $1 million. Its annualized rent roll is $100,000 with operating expenses totaling $40,000. What’s the Cap Rate if average vacancy rate in the area is 5%?
Capitalization Rate = ($100,000 – ($100,000 x 5%) – $40,000) / $1,000,000 = 5.5% Cap
If you know the going Cap Rate for the area, then you can also derive the property value from the NOI.
Cap Rate addresses the limitations of Price Per Unit and Gross Rent Multiplier by including income, vacancy loss, and expenses in its calculation. However by doing so, other problems are introduced.
Precaution #1: Is the Cap Rate Distorted?
Capitalization Rate isn’t flawed, per se. The problem is with Net Operating Income. More often than not, NOI may be inaccurate, which distorts Cap Rate and consequently, misrepresents the estimate of value.
The inaccuracies stem from three primary reasons:
- Misrepresented expenses
- Excluded expenses
- Improper expenses factored into the calculation
Common expenses include insurance, property management, real estate taxes, business fees, maintenance, trash removal, electricity, gas, and water. While reviewing each expense item, confirm the validity of each number. Try and obtain the actual amounts rather than estimates. Are items inappropriately labeled as operating expenses? Remember that depreciation, capital improvements, and mortgage payments are excluded.
Ensuring that expenses are complete and valid will enable you to estimate a more credible value.
Precaution #2 – Is the cap rate calculation based on current or pro forma numbers?
Sometimes sellers or brokers will base their asking price against the future income of the property. This future income is almost always higher resulting in a higher Cap Rate. This tactic is used to lure the unaware investor.
While it’s important to understand the potential upside in rents, projected numbers shouldn’t act as your baseline for estimating value. When estimating value, use current income and expenses. Then evaluate how much premium you’re willing to pay based on projected increases.
Precaution #3 – Financing is not considered.
Investors often use Cap Rate to gauge the potential return of a given investment property during the first year of ownership. Generally, a 10% Cap would indicate a 10% return on investment. Based on expected return, the investor then determines how much they are willing to pay. For investors who pay all cash, Cap Rate enables them to quickly do this.
Since NOI does not consider debt payments, Cap Rate ignores the impact of financing. Cap Rate stays the same whether a property is leveraged or all paid off. If financing is planned, then Cap Rate cannot be used as an estimate of value. Additional methods (ie. cash-on-cash or IRR) are required to assist in that task. However, Cap Rate is still useful as a comparison tool even with financing involved.
Summary
This tutorial has demonstrated when to apply Price Per Unit, Gross Rent Multiplier, and Cap Rate and the considerations to keep in mind. Learning to use the three measurements appropriately will help you to wisely focus your efforts and ultimately speed up your decision making. For information on national and historical cap rates here’s a report from Freddie Mac.
Photo: Taber Andrew Bain
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Capitalization rate is influenced by the cost and structure of financing. The decision to buy depends on several factors. The most influential factors are the Debt Coverage Ratio (DCR), the Annual Debt Constant (ADC), and the Loan to Value ratio (LTV).
Buying an income property is buying an income stream. The value of an income stream is a function of the financing. The income stream is the Net Operating Income (NOI). When using debt financing, the value (Maximum Allowable Offer — MAO) is:
CAP = DCR*ADC*LTV
MAO = NOI/CAP
The equation for CAP rate is derived simply by:
Annual Debt Service: ADS = NOI/DCR
Debt Present Value: DPV = ADS/ADC
Maximum Allowable Offer: MAO = DPV/LTV
(The DPV is of course the amount of debt at the time of acquisition or refinancing.)
Therefore:
MAO = NOI/CAP = ((NOI/DCR)/ADC)/LTV = NOI/(DCR*ADC*LTV)
CAP = DCR*ADC*LTV
When there is debt on the property, the Cash on Cash Return (CCR), which I call the gross Return on Equity (ROE), is also related to the DCR, ADC, LTV:
ROE = (DCR-1)*ADC*LTV/(1-LTV)
The value of the income stream (MAO=NOI/CAP) is directly related to the cost and structure of the available financing (DCR, ADC, LTV). Using CAP rates from comparable sales of similar income properties does not reveal the cost and structure of the financing on those other properties. Your available financing will likely be different from those other properties, and thus require a different CAP rate calculated by the above equations.