Still Confused About Cap Rate? Here’s an Experienced Investor’s Explanation

Still Confused About Cap Rate? Here’s an Experienced Investor’s Explanation

3 min read
Ben Leybovich Read More

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There are a few concepts in real estate investing that are particularly challenging for folks. One of these concepts is the capitalization rate (cap rate). I’ve written on this subject before, but judging by some of the questions on the forums, it’s time for a review. And truthfully, it’s a confusing topic.

What Is Capitalization Rate?

A common misconception is that the cap rate is a property-specific metric. This is not quite right. While the coefficient that is the cap rate can indeed be used to evaluate the performance of a specific asset, what it really does (the origin of the number itself) is illustrate the general behavior in the marketplace as a whole as it relates to risk/reward appetite. Cap rate is a market-driven metric; it is not asset-specific.

Let’s Take a Step Back

Valuation mechanics are easier to understand in the SFR space. In order to assess value of a house, we perform something called comparative market analysis (CMA). As part of CMA, we look to the closed comparable sales (comps) and make adjustments to the price to reflect the condition and amenity package of the subject.

Related: How I’m Earning an 8% Cap Rate With My Vacation Rental

For example, let’s say our subject is a 3/2.5 with a garage. Let’s say that one of the comps, which was a 3/2 without a garage, sold for $110,000. Another comp, which was a 3/2.5 but without a garage, sold for $107,000. What can we glean based on this information?

sell-or-rent-house

Well, for one thing, all things being equal, it seems that in this neighborhood, a garage is a more valuable feature than a half bath. Also, based on this information, we can estimate that our 3/2.5 subject, which has a garage, is likely to be valued more than either of the comps, which had either the half-bath or the garage.

Such is the rationale. The important thing to note here is that what we are comparing is the amenity and condition. Why? Because amenity and condition is what people are buying when purchasing an SFR.

Income Property

When we discuss income property, however, we must understand that what people are buying is the income (at least in the most basic sense). Therefore, it makes sense that the value is somehow pegged on income.

So, what do we need to do in order to establish the value of multifamily? Well, it’s not that different in concept from the SFR. We are going to complete a market study in order to understand what people are paying for similar property—this constitutes the market. However, important to note is that in this case, since we know that what they are really buying is income, we are less interested in the relationship of price to amenity, as in SFR space, and more interested in the relationship between that which people paid and the income that their money was able to buy.

DTI

Cap Rate

In the static sense, the capitalization rate is simply a coefficient which represents this relationship between price and the income this price buys. In each one of these comps, there is a specific rate of return that was projected at the time of acquisition. 

Cap rate, therefore, is just a formula:

Cap Rate = Income/Value  

(Where income is NOI.)

This is what you’ve read in the forums and articles on BiggerPockets. And this is not wrong—the formula is exactly correct.

The trouble is in how you use it. Understand: Cap rate is the measurement of market more than anything else. Why? Because we must look at all of our comps as a whole to extrapolate the mean. For example, let’s say you’ve analyzed 10 closed transactions and discovered that the investors paid in the range of 7%-7.5% capitalization rate for all of these properties.

Related: The Investor’s Complete Guide to Calculating, Understanding & Using Cap Rates

What this tells you is that it takes a 7%-7.5% rate of return to convince investors to deploy capital in this specific marketplace for this asset class. Anything less would require paying higher dollars for this revenue, and this is deemed too risky. Anything more would be welcome, obviously, since it outperforms that market. Cap rate is a measurement of the market as it relates to risk and reward.

What Can You Do With That?

Well, just like you can look at a house and decide that it’s worth $250,000 and not a penny more, you can look at a revenue stream and decide that it’s worth XYZ% return and not anything less. Cap rate tells you what other investors are thinking. Again, cap rate is a market statistic. You, however, have a head on your shoulders and are allowed to either agree or disagree with the market.

The money in real estate is made in the delta between the market valuation and your strategic positioning. When you sell, you have to abide by market conditions. However, in order to build that delta you have to buy right. And to buy right, you may or may not be capitalizing value at all.

Hope this helps a little. Have fun, boys and girls! 

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