Cap rate... I don't understand you.

57 Replies

The cap rate is your expected profit after all expenses divided by how much you paid for the property if you paid all cash. Lets take a real simple example. 

You pay $100,000 for a property. You rent it for $1,000 a month ($12,000 a year) . You have expenses of $5,000 a year. So your profit is $7,000 a year. Your cap rate is then 7%. ($7,000 profit divided by $100,000 purchase price)

Originally posted by @Edward Damhuis :

I know what the definition of a cap rate is but for some reason it's not sinking in. Can someone please elaborate just a tad for me?

Think of it as a comp much like comparing dollar per square foot. If properties have sold for around $400 a square foot then you could get to a probable market value of your sf times $400. Cap rate is a valuation tool used only for commercial and large residential properties. If similar property's NOI has sold for 10% cap rate then your NOI should also sell for around a 10% cap rate.

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@Russell Brazil ... I understand the math, and the explanation of what it is... I guess I'm having a harder time understanding it's purpose. So a seller uses a cap rate to charge more for a property? Other than what the number tells you, how else does it factor into a purchase? Maybe that's more my question. Thank you for the help!

Originally posted by @Edward Damhuis :

Russell Brazil ... I understand the math, and the explanation of what it is... I guess I'm having a harder time understanding it's purpose. So a seller uses a cap rate to charge more for a property? Other than what the number tells you, how else does it factor into a purchase? Maybe that's more my question. Thank you for the help!

 Ok...well first you should know its typically used to analyze commercial properties, and not residential properties of 4 units or less.

So it is away to determine how much of a return on your investment you will get. If I want to invest my $100,000 and there is a building that the cap rate is 6% and another where the cap rate is 8%, then maybe I think to myself Im going to invest in the one that is 8% because Im going to make $2,000 more on the year if I buy that one. So it is a simple mathematical expression of how much profit I am going to get from deploying my money.

However it is important to note that the cap rate is just one single tool someone should use to analyze a property. Often a high risk property, think one in a poorer area, or one more prone to crime, will carry a higher cap rate than the area. A nicer low crime area might have a lower cap rate. So with a riskier investment you may get a higher cap rate. BUT, this is just one tool for your analysis. The property in the nicer area with the lower cap rate might appreciate more over time, and thus might have a higher IRR, Internal Rate of Return, (This factors in all the methods to make money on the property) than the one in the poorer area.

Originally posted by @Russell Brazil :

The cap rate is your expected profit after all expenses divided by how much you paid for the property if you paid all cash. Lets take a real simple example. 

You pay $100,000 for a property. You rent it for $1,000 a month ($12,000 a year) . You have expenses of $5,000 a year. So your profit is $7,000 a year. Your cap rate is then 7%. ($7,000 profit divided by $100,000 purchase price)

Well that is basically true but I would argue that you cannot call that $7,000 profit because at the end of the year the boiler goes out and cost $18,000 so there goes any "profit".  It would be correctly called your Net Operating Income.

And while you did CREATE a 7% cap rate by your purchase you would have been better to look at what other people paid for the exact same NOI so that you don't over pay. Lets say all prior sales for $7,000 NOI have gone for $80,000. Your property is similar to these sales so you would say I'm buying a $7,000 NOI. The market is buying these at $80,000. That is an 8.75% cap rate ($7000/$80,000). You would not want to pay more than market. So computing the cap rate using your purchase price does not tell you that you overpaid $20,000.

@Bob Bowling Oh I agree...I was just trying to boil it down to the most basic description and put it into laymens terms. In my example profit could be converted to NOI. I also wasnt trying to use numbers that were realistic, just ones that provided for very easy math.

Originally posted by @Russell Brazil :
Originally posted by @Edward Damhuis:

Russell Brazil ... I understand the math, and the explanation of what it is... I guess I'm having a harder time understanding it's purpose. So a seller uses a cap rate to charge more for a property? Other than what the number tells you, how else does it factor into a purchase? Maybe that's more my question. Thank you for the help!

 Ok...well first you should know its typically used to analyze commercial properties, and not residential properties of 4 units or less.

So it is away to determine how much of a return on your investment you will get. If I want to invest my $100,000 and there is a building that the cap rate is 6% and another where the cap rate is 8%, then maybe I think to myself Im going to invest in the one that is 8% because Im going to make $2,000 more on the year if I buy that one. So it is a simple mathematical expression of how much profit I am going to get from deploying my money.

Buildings DO NOT have cap rates until they are sold. The market dictates the cap rate. Now someone can calculate a cap rate based on the ASKING PRICE but that means nothing. NOw you can look at different markets and say a $10,000 NOI sells for $200,000 in San Francisco at a 5% cap rate but the exact same possible NOI of $10,000 would maybe sell for $100,000 in Indy at a 10% cap rate. The market is saying there is a chance of collecting $10,000 on both properties but they are willing to pay TWICE as much for it in SF. Wonder why that is?

Edward,

Since math is not the problem, lets try this;

Firstly, is not used by the Seller to 'charge more'. As with any other ratio, is a 'short hand' way of communicating information BETWEEN potential Seller and potential Buyer.

From the Sell side, leaving aside all the shall we say questionable numbers that are assumed, wrong or even simply misrepresented, the Seller (or agent) uses the P & L statement (proforma or actual) along with the listing price to represent what the profitability of the property could be or in fact is.

From the Buy side, it is a way, after receiving information, making a bunch of assumptions and crunching a bunch of numbers, to compare possible purchases. Having said that, it does not account for relative risk or return.

A Buyer can also use the Sellers number to do preliminary screening. An example;

You are an investor targeting distressed properties with high returns (e.g. >12%) and risk. A Seller lists a property and represents an 6% CAP rate. Assuming it is unlikely that you will be able to turn a 6 CAP into a 12 CAP, you decide to not waste your time (or theirs) in asking for and analyzing any information.

You are a semi-retired investor who want a 'safer' investment. You also know that most investments that would fit your criteria, are in the 6-7 CAP range. You see an listing that says that it is a 12 CAP. Since a Seller would generally not undervalue their property (a 12 CAP is half the price of a 6 CAP at the same purchase price), you move on.

In both cases, there are always exceptions. In the first example, the rents may be dramatically under market and can be raised almost immediately making the property a 12 CAP. In the second case, the Seller has a loan due and needs to close in 2 weeks so is offering it at a bargain price. While infrequent, even rare, these things do happen.

As an investor, using the advertised CAP rate to do a preliminary screen is quite a common way to save time and effort but takes the chance of missing out on the unicorn deal ;)

Hope this helps.

Oren

Originally posted by @Oren K. :

Edward,

Since math is not the problem, lets try this;

Firstly, is not used by the Seller to 'charge more'. As with any other ratio, is a 'short hand' way of communicating information BETWEEN potential Seller and potential Buyer.

From the Sell side, leaving aside all the shall we say questionable numbers that are assumed, wrong or even simply misrepresented, the Seller (or agent) uses the P & L statement (proforma or actual) along with the listing price to represent what the profitability of the property could be or in fact is.

From the Buy side, it is a way, after receiving information, making a bunch of assumptions and crunching a bunch of numbers, to compare possible purchases. Having said that, it does not account for relative risk or return.

A Buyer can also use the Sellers number to do preliminary screening. An example;

You are an investor targeting distressed properties with high returns (e.g. >12%) and risk. A Seller lists a property and represents an 6% CAP rate. Assuming it is unlikely that you will be able to turn a 6 CAP into a 12 CAP, you decide to not waste your time (or theirs) in asking for and analyzing any information.

You are a semi-retired investor who want a 'safer' investment. You also know that most investments that would fit your criteria, are in the 6-7 CAP range. You see an listing that says that it is a 12 CAP. Since a Seller would generally not undervalue their property (a 12 CAP is half the price of a 6 CAP at the same purchase price), you move on.

In both cases, there are always exceptions. In the first example, the rents may be dramatically under market and can be raised almost immediately making the property a 12 CAP. In the second case, the Seller has a loan due and needs to close in 2 weeks so is offering it at a bargain price. While infrequent, even rare, these things do happen.

As an investor, using the advertised CAP rate to do a preliminary screen is quite a common way to save time and effort but takes the chance of missing out on the unicorn deal ;)

Hope this helps.

Oren

Oren,

1.  Under market rents DO NOT change the cap rate.

2.  If you see a listing at a 12% cap rate in a 6-7% cap rate market you can be 99% sure that the cap rate was NOT calculated correctly.

3.   An investor using "advertised" cap rates as a screening tool is an idiot.  The market sets the cap rate.  An investor uses market cap rates to reach market values.  No one "buys" a cap rate.  When you make an offer based on the market cap THEN you screen out idiot sellers that don't want to sell their properties.

@Edward Damhuis ,

Another way to look at the Cap rate (short for "Capitalization Rate"): 

It's a rough indicator of how quickly the NOI from the property will pay for it. The higher the Capitalization Rate, the longer the pay-back time relative to the purchase price. The lower the Capitalization Rate the shorter the pay back time relative to the purchase price.

Thus, with a 10-Cap, a $200,000 property will pay back at the same speed as a $100,000, to borrow from the earlier example. Of course, the higher the purchase price the longer you'll "run at that speed" to pay it off.

Just as 60 MPH will take you 60 miles in one hour, 60 MPH will take you 120 miles in two hours. Same speed over longer time takes you farther.

Same with money. 10% per year for 10 years will pay back less than it will pay back over 20 years. $100,000 will pay back in 10 years, $200,000 in 20 years. Same pay-back rate, longer time.

With Cap rate, however, the lower the value the higher the "speed" (faster pay-back rate).

At 120 MPH at 10-Cap, you'd go 60 miles in 30 minutes, 120 miles in a single hour.

Same with money. At a 5-Cap, you'd pay back $100,000 in less time than at a 10-Cap.

Sorry if that just muddies the waters for you. Wanted to give you a different paradigm of it.

@Bob Bowling - question on your statement about "1. Under market rents DO NOT change the cap rate."  

Converting to market rent would just change the price investors would be willing to pay if they were to pay the price dictated by the market cap rate, right?

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Originally posted by @David Dachtera :

@Edward Damhuis ,

It's a rough indicator of how quickly the NOI from the property will pay for it. At a 5-Cap, you'd pay back $100,000 in less time than at a 10-Cap.

Sorry if that just muddies the waters for you. Wanted to give you a different paradigm of it.

Aaaaaarg!  

1.  It is not a time metric.

2.  It only looks at one years financials.

3.  Check your math.

Bob,

You are off course correct on 1 & 2. These were just hypothetical examples to illustrate the point.

In the first example, the Buyer see an opportunity to turn a 6 CAP into a 12 CAP. There is no guarantee that they will be able to push through the rent increases. I would also agree that it is very unlikely almost impossible without turning over the entire tenant base and the costs that creates which then changes the investment returns.

In the second example, you are 99% correct but every once in a while, a unicorn does come along. If you are in the right place at the right time and have the capability to make it happen (CASH IS KIING!); well lets just say that stranger things have happened. I would bet a bunch of bananas (or pineapples for you ;) that if we polled BP for their 'best deal ever', even wilder deals have happened.

On the third point, I disagree with you. In my opinion, it is a perfectly legitimate way of preliminary screening. At the end of the day, how you chose to invest your time, is your choice. Your method may lead you to more deals, which is great, but it also requires more time that someone else may not have or be willing to spend.

Oren

Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:

@Edward Damhuis ,

It's a rough indicator of how quickly the NOI from the property will pay for it. At a 5-Cap, you'd pay back $100,000 in less time than at a 10-Cap.

Sorry if that just muddies the waters for you. Wanted to give you a different paradigm of it.

Aaaaaarg!  

1.  It is not a time metric.

2.  It only looks at one years financials.

3.  Check your math.

1. Well, yeah, technically, it sort of is: a property with a lower Capitalization rate (ratio) will pay back faster than one with a lower Capitalization Rate (ratio). Your speedometer in your car is not a measure of time, either, strictly speaking. It's a measure of progress over time: how fast do you get there. Capitalization Ratio says, "How fast does NOI get this paid off?"

2. If you're only looking at one year's financials, you're doing it wrong. If one year is all you can get, remember that going forward your initial analysis is of a lower quality than you would like. Go back and review the Multi-Family classes, Day 1 & 2. You have lifetime access if you meet certain criteria, depending when your three years was up, originally.

3. The numbers here are for illustration purposes, only.

Originally posted by @Samir Pathak :

@Bob Bowling - question on your statement about "1. Under market rents DO NOT change the cap rate."  

Converting to market rent would just change the price investors would be willing to pay if they were to pay the price dictated by the market cap rate, right?

Exactly. Let's say rents are half what they should be and assume (probably incorrectly) that NOI will double also.

In either instance the property is capable of generating $10,000 NOI. If the market is buying similar properties with potential $10,000 NOI at 10% cap rate then the property is worth $100,000. But the property is only generating $5,000 NOI. But it will only take one month to get the rents increased and you'd lose less than $2,000 in rents and have mailing costs of maybe $100 to notify of rent increases so maybe $2,000 hard costs but you are also taking a risk that the market will change so you want a risk discount. That you will have to negotiate so maybe you can talk the seller into a $10,000 discount off the Market value of $100,000 and buy at $90,000. The market will look at your sale and think hey tht property sold at a 11.1% cap rate BUT people in the know will say correctly that you bought at a 10% cap rate with a $10,000 below the line adjustment because of the under performing rents.

Originally posted by @Oren K. :

On the third point, I disagree with you. In my opinion, it is a perfectly legitimate way of preliminary screening. At the end of the day, how you chose to invest your time, is your choice. Your method may lead you to more deals, which is great, but it also requires more time that someone else may not have or be willing to spend.

Oren

3. An investor using "advertised" cap rates as a screening tool is an idiot. The market sets the cap rate. An investor uses market cap rates to reach market values. No one "buys" a cap rate. When you make an offer based on the market cap THEN you screen out idiot sellers that don't want to sell their properties.

Your method of screening by "asking price" would only take LESS time if all properties SOLD for asking price.  Otherwise you have to keep computing it each time your offer price or the counter offer price changes.  Way easier and less time consuming to ignore asking price and just make offers on market value.  A seller that wants to sell will not ignore a market price offer. 

Originally posted by @David Dachtera :
Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:

2.  It only looks at one years financials.

2. If you're only looking at one year's financials, you're doing it wrong. 

By definition a cap rate only looks at one years financials.  Can you illustrate how you would use more than one years financials?   

Originally posted by @David Dachtera :
Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:

@Edward Damhuis ,

It's a rough indicator of how quickly the NOI from the property will pay for it. At a 5-Cap, you'd pay back $100,000 in less time than at a 10-Cap.

Sorry if that just muddies the waters for you. Wanted to give you a different paradigm of it.

Aaaaaarg!  

3.  Check your math.

1. Well, yeah, technically, it sort of is: a property with a lower Capitalization rate (ratio)  will pay back faster than one with a lower Capitalization Rate (ratio). 

1.   5% is a lower cap rate than 10%

2. $10,000 NOI bought at 5% = $200,000

3. $10,000 NOI bought at 10% =$100,000

IF the property performs as on paper then it will take 20 years of NOI to pay off the $200,000 purchase.

IF the property performs as on paper then it will take 10 years if NOI to pay off the $100,000 purchase.

4.  20 > 10

5.  10% > 5%

6.  Therefore the lower cap rate WILL NOT pay back FASTER.

Although the market is saying they think the 5% cap rate market will be more profitable.

Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:
Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:

2.  It only looks at one years financials.

2. If you're only looking at one year's financials, you're doing it wrong. 

By definition a cap rate only looks at one years financials.  Can you illustrate how you would use more than one years financials?   

The same way you would use one year. Are the numbers consistent year-to-year? Do the trends match market conditions / trends? If there are variations in NOI / expenses, what were the causes?

The more data you have the better your analysis will be.

Originally posted by @David Dachtera :
Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:
Originally posted by @Bob Bowling:
Originally posted by @David Dachtera:

2.  It only looks at one years financials.

2. If you're only looking at one year's financials, you're doing it wrong. 

By definition a cap rate only looks at one years financials.  Can you illustrate how you would use more than one years financials?   

The same way you would use one year. Are the numbers consistent year-to-year? Do the trends match market conditions / trends? If there are variations in NOI / expenses, what were the causes?

The more data you have the better your analysis will be.

BUT that is not the definition of a cap rate.  I am not arguing against using multiple years of data.  It is just that is NOT the purpose of a cap rate and is one of it's faults.

Heck, I use decades of data when appropriate but a cap rate is designed to use only one years financials.

Please illustrate how you would correctly use multiple years of income and expenses to calculate NOI. You will not be able to.

The idea behind a cap rate is it will show you what percent return the investment will make if it was bought for cash and has no debt on it. So a 10 cap is really a 10% return on an all cash purchase. The reason to do this is because the type of debt structure you have (LTV, interest rate, amortization, etc.) will effect the return, but how good of financing you can get doesn't effect the value of the asset (unless there is seller financing involved).

Thus, a cap rate is a great way to compare one property to another.