{"id":101897,"date":"2018-08-30T14:30:16","date_gmt":"2018-08-30T20:30:16","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=101897"},"modified":"2021-03-16T14:50:07","modified_gmt":"2021-03-16T20:50:07","slug":"burning-questions-cap-rate-noi","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/burning-questions-cap-rate-noi","title":{"rendered":"5 of Your Most Burning Questions About Cap Rate, NOI & More\u2014Answered"},"content":{"rendered":"

The best way to write, in my opinion, is to simply answer questions. Most times, I have to sit down and think,\u00a0What do these guys want to know about?<\/em>\u00a0Sometimes, however, the process is made much easier when someone directly asks questions, either here or in the forums<\/a>.<\/p>\n

Now, I happen to be an equal opportunity answerer of questions in that I don’t care much how good my articles are for the SEO or how many people are interested in the answers. I take the view that if I can help one guy in a substantive way, my time is well spent.<\/p>\n

That said, I am not sure how many of you will relate to or find this article useful, but I know that at least one person by the name of Johnny will appreciate this. Johnny was the one to ask me these questions in the article I published last week<\/a>, and I provided a bit of feedback, which I will now elaborate upon.<\/p>\n

The Questions<\/h2>\n

Mr. Leybovich,<\/em><\/p>\n

1.)\u00a0<\/em>You commented, \u201cWe are less concerned with the in-place cap rate and much more concerned with the cap rate after the repositioning.\u201d I thought the lower your cap rate is, the higher you’re paying for that stream of income, future appreciation\/upside, loan pay-down, tax benefits. And if you\u2019re paying a lower cap rate and higher price, will that not affect your exit strategy or return? You are not the only one I\u2019ve heard say, “Entry cap rates aren\u2019t as important.\u201d I\u2019m not saying you’re wrong, I just don\u2019t understand. Can you please explain this rationale?<\/em><\/p>\n

2.)\u00a0<\/em>You mentioned \u201cA 25% improvement to the top line, all of which flows through to the NOI. What is currently a 5% cap rate becomes a 6.25% cap rate just by reaching the national average on rents.\u201d Can you please explain the math on how a 5% cap rate instantly becomes 6.25% cap rate and why you want a higher cap rate while you own a deal?<\/em><\/p>\n

3.)\u00a0<\/em>Also, in your example, you said, \u201cA 25% value-add program, and you go from a 5% cap rate in Y1 to a 8.3% cap rate in Y3\u201d How did you calculate the cap rate for each year?<\/em><\/p>\n

4.)\u00a0<\/em>You wrote, \u201cBecause even after we inflate cap rates in the future, which we should do[…]\u201d Why would you want to inflate your future cap rate when your strategy has to do with exiting this investment? Don\u2019t you want to exit at a lower cap rate to realize a higher disposition price?<\/em><\/p>\n

5.)\u00a0<\/em>\u201cThat delta is where we make money.\u201d I\u2019ve heard \u201cdelta\u201d being used before ,but I don\u2019t understand even after Googling, and the examples that were given had to do with stocks and options. What does delta in the real estate investment world mean?<\/em><\/p><\/blockquote>\n

Let’s take this one by one. I will leave the questions in italics, and answer them with a designation BL:<\/strong><\/p>\n

\"property-management-contract\"
\n
\nRelated:<\/strong> Still Confused About Cap Rate? Here\u2019s an Experienced Investor\u2019s Explanation<\/a><\/em><\/p>\n

Question #1<\/h3>\n

Mr. Leybovich,\u00a0<\/em><\/p>\n

BL:\u00a0<\/strong>Johnny, Ben is just fine. I know I am way older than Brandon Turner, but “Mr. Leybovich” is not necessary. \ud83d\ude42<\/p>\n

1.)\u00a0<\/em>You commented, \u201cWe are less concerned with the in-place cap rate and much more concerned with the cap rate after the repositioning.\u201d I thought the lower your cap rate is, the higher you’re paying for that stream of income, future appreciation\/upside, loan pay-down, tax benefits. And if you\u2019re paying a lower cap rate and higher price, will that not affect your exit strategy or return? You are not the only one I\u2019ve heard say, “Entry cap rates aren\u2019t as important.\u201d I\u2019m not saying you’re wrong, I just don\u2019t understand. Can you please explain this rationale?<\/em><\/p>\n

BL:\u00a0<\/strong>Estimating the value based on income requires two major inputs. One is the net operating income (NOI), and the other is the capitalization rate.<\/p>\n

Have you ever really considered what cap rate really is? Mathematically, obviously, it’s just a coefficient or a multiplier. But what does it really mean or stand for? Is it an arbitrary number that you pull out of your you-know-what, or if not, what is it?<\/p>\n

The best way I know to describe what cap rate is is with this question:<\/p>\n

What is the rate of return that most reasonably aggressive buyers would be willing to deploy capital at for an asset such as this in this location?<\/p>\n

Notice that the question is not posed to one specific buyer, but the marketplace as a whole. As such, the answer to the question does less to describe a rate of return on a specific asset and more to underscore overall behavior of buyers in a specific marketplace as it relates to an asset class.<\/p>\n

Now, it is correct that a lower capitalization of the NOI indicates a higher purchase price. It also indicates the certain intrinsic strength of the marketplace. But remember, we are working off of two inputs\u2014the NOI and the cap rate.<\/p>\n

Let’s say I pay a 5% cap rate for an asset. In your mind, I paid quite a hefty price, and I agree\u2014I would have loved to buy this asset at a 7% cap rate instead. But the market didn’t let me. However, if I am able to improve the NOI, then capitalizing a value at the same 5% cap rate will give me a higher exit price, which is what I want.<\/p>\n

In other words, it’s important to remember that for our search of the delta, we can either buy certain NOI at a higher cap rate and sell at a lower cap rate\u2014or we can buy in-place NOI, improve it, and sell at the same NOI we purchased at, but because the NOI is higher, so is the exit.<\/p>\n

Since markets are rational, no one is going to let you buy an asset that the marketplace has decided is worth a 5% cap rate at a 7% cap rate in 2018. Therefore, the only answer is to buy value-add.<\/p>\n

Questions #2 & 3<\/h3>\n

2.)\u00a0<\/em>You mentioned \u201cA 25% improvement to the top line, all of which flows through to the NOI. What is currently a 5% cap rate becomes a 6.25% cap rate just by reaching the national average on rents.\u201d Can you please explain the math on how a 5% cap rate instantly becomes 6.25% cap rate and why you want a higher cap rate while you own a deal?<\/em><\/p>\n

3.)\u00a0<\/em>Also, in your example, you said, \u201cA 25% value-add program, and you go from a 5% cap rate in Y1 to a 8.3% cap rate in Y3\u201d How did you calculate the cap rate for each year?<\/em><\/p>\n

BL:\u00a0<\/strong>First, the process is not instant. It takes time to burn through the delta. However, if you purchase an asset for $8.15M with an in-place NOI of around $400,000, this means you’ve purchased it at a bit under a 5% cap rate. Let’s round it up to 5%.<\/p>\n

Let’s say that rents increase by 25%. Those rent increases do not have any operating expenses (OpEx<\/a>) attached to them, because in this question I am discussing market trends and not the value-add. If that happens, the NOI shoots up to $500,000.
\n
\nRelated:<\/strong> I\u2019ll Never Buy Another Multifamily Without This $75,000 Tool That Added $1.3M Value in Less Than 12 Months<\/a><\/em><\/p>\n

At the same basis of $8.15M, the new NOI of $500,000 now constitutes a 6.13% cap rate. Now, if you take the national average apartment rent of over $1,300 compared to under $1,000 in Phoenix, this is closer to a 28% delta, not 25%, which is why in the original article the example was a 5% cap rate to a 6.25% cap rate.<\/p>\n

The same logic applies to the value-add, aside from the fact that when considering the improved NOI, we need to add the cost of getting it there into our basis. Thus, if the purchase price is $8.15M and the cost of rehab is $1.4M, the new basis is now about $9.55M. The after-reposition cap rate needs to juxtapose the new and improved NOI to the new increased basis.<\/p>\n

\"\"<\/p>\n

Question #4<\/h3>\n

4.)\u00a0<\/em>You wrote, \u201cBecause even after we inflate cap rates in the future, which we should do[…]\u201d Why would you want to inflate your future cap rate when your strategy has to do with exiting this investment? Don\u2019t you want to exit at a lower cap rate to realize a higher disposition price?<\/em><\/p>\n

BL:\u00a0<\/strong>If we don’t assume an inflated cap rate for our exit, then what we are saying in effect is that market demand will forever remain at the same level it currently is. Since I have no proof that this will be the case, specifically not in an increasing interest rate environment, I have to assume the cap rates will eventually start going up.<\/p>\n

This is a long conversation, actually. And quite involved to boot. Maybe next time.<\/p>\n

Question #5<\/h3>\n

5.)\u00a0<\/em>\u201cThat delta is where we make money.\u201d I\u2019ve heard \u201cdelta\u201d being used before ,but I don\u2019t understand even after Googling, and the examples that were given had to do with stocks and options. What does delta in the real estate investment world mean?<\/em><\/p>\n

Thank you for taking your most valuable asset, which is time, to respond! I hope others will benefit from my questions.<\/em><\/p>\n

BL:\u00a0<\/strong>If you still don’t know, re-read the article.<\/p>\n

Hope this helps!<\/p>\n

\"\"<\/a><\/p>\n

So, let’s hear it\u2014what are your other burning questions regarding real estate numbers and analysis?<\/em><\/p>\n

Comment below!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

Do the terms “cap rate,” “NOI,” “repositioning,” and “value-add” have your head spinning? Learn to wrap your mind around these important real estate concepts here.<\/p>\n","protected":false},"author":810,"featured_media":98831,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[5527],"tags":[],"class_list":["post-101897","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-commercial-real-estate-investing"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/101897","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/810"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=101897"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/101897\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/98831"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=101897"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=101897"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=101897"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}