Capitalization rate (cap rate)
Alabaster, AL · Member since 2017 · 10 posts · 2 votes
Amy from AL here...what is cap rate? What's a good cap rate and why? What's a bad cap rate and why?
What is a cap rate? The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
Cap Rate = Annual Net operating income / cost ( or value)
Most of time class A areas are usually lower and the class C buildings are usually a higher cap rate.
Class A buildings are more expensive maybe less maintenance, *possibly* less management intensive.
Cap rates vary depending on locality. San Francisco has rent control cap rates are like 3-4.X% you pray for people to leave and you try super hard to evict people for cause. Kansas City Mo has cap rates around 15-20% for 2-4 units and then 6.X-8% for slightly larger multi family.
Phoenix has cap rates of 5.X - 8.X depending on the building class and the area.
If you're in an area that's trendy where people want to live those buildings are usually more expensive and the cap rates are usually lower.
What is a cap rate? The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
Cap Rate = Annual Net operating income / cost ( or value)
Most of time class A areas are usually lower and the class C buildings are usually a higher cap rate.
Class A buildings are more expensive maybe less maintenance, *possibly* less management intensive.
Cap rates vary depending on locality. San Francisco has rent control cap rates are like 3-4.X% you pray for people to leave and you try super hard to evict people for cause. Kansas City Mo has cap rates around 15-20% for 2-4 units and then 6.X-8% for slightly larger multi family.
Phoenix has cap rates of 5.X - 8.X depending on the building class and the area.
If you're in an area that's trendy where people want to live those buildings are usually more expensive and the cap rates are usually lower.
Thank you, @Jason Monroe!
As to what is a good CAP rate and what is a bad CAP rate, it depends on what your strategy and risk tolerance is. CAP rate is set by the market and is often a reflection of risk and growth prospects for that market. For example, in the ghetto the growth prospects are generally not as good and the tenant quality is generally lower (which can lead to more risk and more volatile cash flow) ... to compensate for this limited upside and added risk, the market prices these properties lower in comparison to the rental income they are capable of producing on paper, resulting in a higher CAP rate. The opposite effect causes a lower CAP rate in the nicer neighborhoods with better growth prospects ... both prices and rents are higher in absolute dollars, but not proportionally resulting in a lower CAP rate.
As for strategy, if you want immediate income and are willing to handle the more intensive management and risk, then a high CAP rate property may be what you are looking for since you pay less for a higher (but likely more volatile) Net Operating Income (NOI). On the other hand if your strategy is to do a value add renovation and/or want a less management intensive property with higher growth prospects, then a low CAP rate property may be better for you. To illustrate why this is better for value add (aka forced appreciation), lets say you work to fix up your property and as result you increase rents and increase NOI by $10,000/yr. If you do this on a 10 CAP property, you just increased the value of your property by $100,000 (NOI/CAP = $10,000/0.1 = $100,000) ... if you do this same amount of work to raise rents by $10,000 on a 5 CAP property, then you increased the value of that property by $200,000 ($10,000/0.05) or twice as much forced appreciation for the same NOI increase!
Note that CAP rates only apply to commercial property (5 or more units). 4 or fewer units is residential property and CAP rates do not apply ... those use comparable sales to determin fair market value. So, if somebody tries to sell you on a property with 4 or fewer units by telling you how great the CAP rate is, then that person either has no idea what they are talking about, is trying to con you, or both ... either way, you should run for the hills!
@Amy Sommers , cap rates vary wildly from State to state and city to city. The higher the rate - the cheaper you are purchasing the property for. It seems counter-intuitive - higher = less expensive. Example - in Kansas City you might see a cap rate in the city of 6 to 8%. In NYC or LA you will see 2 to 3% as your cap rate.
Hope that helped.
Over time, cap rates change. When interest rates are low money flows to real estate as people seek yield. That makes buildings more expensive. When interest rates rise the yield rises and building values fall.
@seth borman
Your statement above: "When interest rates rise the yield rises and building values fall." Would the value of a building really fall when it makes more money? Wouldn't the value of the building rise instead?
Cheers... Immanuel
@Immanuel Sibero yes. Investors want to achieve a certain yield. If I can get 14% in treasury bonds like 1980 then I'm going to want much more than that for a risky Class C apartment building in South Dallas, right?
So NOI doesn't change but the expect yield does, which means value falls.
I read your post and interpreted "yield rises..." as the building's NOI had actually increased (which, as you have clarified, is not the case). To me it would have made more sense when interest rates rise cap rates would rise which would result in lower valuations. Cap rates are more a valuation metric than a performance/yield metric. I get confused when they are used interchangeably.
Cheers.
I'm using cap rate and yield interchangeably.
Brett has a good explanation.
The coolest thing about cap rates are that you can work the equations both ways. NOI or the cap rate can change, either of which will effect valuation
Wow! Thanks to all who provided additional insight.
Amy,
Great question. Glad you had the courage to ask. many of us, me included are afraid to ask questions when what we really should be afraid of is not knowing the answer. Thanks
As to what is a good CAP rate and what is a bad CAP rate, it depends on what your strategy and risk tolerance is. CAP rate is set by the market and is often a reflection of risk and growth prospects for that market. For example, in the ghetto the growth prospects are generally not as good and the tenant quality is generally lower (which can lead to more risk and more volatile cash flow) ... to compensate for this limited upside and added risk, the market prices these properties lower in comparison to the rental income they are capable of producing on paper, resulting in a higher CAP rate. The opposite effect causes a lower CAP rate in the nicer neighborhoods with better growth prospects ... both prices and rents are higher in absolute dollars, but not proportionally resulting in a lower CAP rate.
As for strategy, if you want immediate income and are willing to handle the more intensive management and risk, then a high CAP rate property may be what you are looking for since you pay less for a higher (but likely more volatile) Net Operating Income (NOI). On the other hand if your strategy is to do a value add renovation and/or want a less management intensive property with higher growth prospects, then a low CAP rate property may be better for you. To illustrate why this is better for value add (aka forced appreciation), lets say you work to fix up your property and as result you increase rents and increase NOI by $10,000/yr. If you do this on a 10 CAP property, you just increased the value of your property by $100,000 (NOI/CAP = $10,000/0.1 = $100,000) ... if you do this same amount of work to raise rents by $10,000 on a 5 CAP property, then you increased the value of that property by $200,000 ($10,000/0.05) or twice as much forced appreciation for the same NOI increase!
Note that CAP rates only apply to commercial property (5 or more units). 4 or fewer units is residential property and CAP rates do not apply ... those use comparable sales to determin fair market value. So, if somebody tries to sell you on a property with 4 or fewer units by telling you how great the CAP rate is, then that person either has no idea what they are talking about, is trying to con you, or both ... either way, you should run for the hills!
Great information David. Out of curiosity why is it that cap rates are only relative to commercial properties and not residential?
As to what is a good CAP rate and what is a bad CAP rate, it depends on what your strategy and risk tolerance is. CAP rate is set by the market and is often a reflection of risk and growth prospects for that market. For example, in the ghetto the growth prospects are generally not as good and the tenant quality is generally lower (which can lead to more risk and more volatile cash flow) ... to compensate for this limited upside and added risk, the market prices these properties lower in comparison to the rental income they are capable of producing on paper, resulting in a higher CAP rate. The opposite effect causes a lower CAP rate in the nicer neighborhoods with better growth prospects ... both prices and rents are higher in absolute dollars, but not proportionally resulting in a lower CAP rate.
As for strategy, if you want immediate income and are willing to handle the more intensive management and risk, then a high CAP rate property may be what you are looking for since you pay less for a higher (but likely more volatile) Net Operating Income (NOI). On the other hand if your strategy is to do a value add renovation and/or want a less management intensive property with higher growth prospects, then a low CAP rate property may be better for you. To illustrate why this is better for value add (aka forced appreciation), lets say you work to fix up your property and as result you increase rents and increase NOI by $10,000/yr. If you do this on a 10 CAP property, you just increased the value of your property by $100,000 (NOI/CAP = $10,000/0.1 = $100,000) ... if you do this same amount of work to raise rents by $10,000 on a 5 CAP property, then you increased the value of that property by $200,000 ($10,000/0.05) or twice as much forced appreciation for the same NOI increase!
Note that CAP rates only apply to commercial property (5 or more units). 4 or fewer units is residential property and CAP rates do not apply ... those use comparable sales to determin fair market value. So, if somebody tries to sell you on a property with 4 or fewer units by telling you how great the CAP rate is, then that person either has no idea what they are talking about, is trying to con you, or both ... either way, you should run for the hills!
Great information David. Out of curiosity why is it that cap rates are only relative to commercial properties and not residential?
Comment: A savvy investor can take advantage of these things, like buying residential when and where the comps crash in price (assuming they are confident the crash is temporary and prices will come back) or on flips adding features that may not raise rents much but cost little and still raise the value significantly. On the other hand, unsophisticated investors can easily get ripped off if they don't understand this. Certain providers will inflate net income projections on a single family property to back out a high CAP rate for it to brag about what a great deal the property is, when in reality they are trying to sell it above sold comparables in the market and it is a complete rip off but since newbies don't know that market and don't know how to properly value SFRs they never see it until years in when the income projections don't pan out and they can't sell it for anywhere near what they bought it for.
As to what is a good CAP rate and what is a bad CAP rate, it depends on what your strategy and risk tolerance is. CAP rate is set by the market and is often a reflection of risk and growth prospects for that market. For example, in the ghetto the growth prospects are generally not as good and the tenant quality is generally lower (which can lead to more risk and more volatile cash flow) ... to compensate for this limited upside and added risk, the market prices these properties lower in comparison to the rental income they are capable of producing on paper, resulting in a higher CAP rate. The opposite effect causes a lower CAP rate in the nicer neighborhoods with better growth prospects ... both prices and rents are higher in absolute dollars, but not proportionally resulting in a lower CAP rate.
As for strategy, if you want immediate income and are willing to handle the more intensive management and risk, then a high CAP rate property may be what you are looking for since you pay less for a higher (but likely more volatile) Net Operating Income (NOI). On the other hand if your strategy is to do a value add renovation and/or want a less management intensive property with higher growth prospects, then a low CAP rate property may be better for you. To illustrate why this is better for value add (aka forced appreciation), lets say you work to fix up your property and as result you increase rents and increase NOI by $10,000/yr. If you do this on a 10 CAP property, you just increased the value of your property by $100,000 (NOI/CAP = $10,000/0.1 = $100,000) ... if you do this same amount of work to raise rents by $10,000 on a 5 CAP property, then you increased the value of that property by $200,000 ($10,000/0.05) or twice as much forced appreciation for the same NOI increase!
Note that CAP rates only apply to commercial property (5 or more units). 4 or fewer units is residential property and CAP rates do not apply ... those use comparable sales to determin fair market value. So, if somebody tries to sell you on a property with 4 or fewer units by telling you how great the CAP rate is, then that person either has no idea what they are talking about, is trying to con you, or both ... either way, you should run for the hills!
Great information David. Out of curiosity why is it that cap rates are only relative to commercial properties and not residential?
Comment: A savvy investor can take advantage of these things, like buying residential when and where the comps crash in price (assuming they are confident the crash is temporary and prices will come back) or on flips adding features that may not raise rents much but cost little and still raise the value significantly. On the other hand, unsophisticated investors can easily get ripped off if they don't understand this. Certain providers will inflate net income projections on a single family property to back out a high CAP rate for it to brag about what a great deal the property is, when in reality they are trying to sell it above sold comparables in the market and it is a complete rip off but since newbies don't know that market and don't know how to properly value SFRs they never see it until years in when the income projections don't pan out and they can't sell it for anywhere near what they bought it for.
Makes perfect sense thanks for the explanation!
Over the last couple of months I've been a few places around the country. During that time some of the things that you'll also need to put into your calculations.
- Turn costs
- Vacancy discount
In the SF Bay Area where rents might not rise that sharply for units not owned by larger corps or in rent control areas you're typically not going to see a lot of turn over
In places like Indianapolis (C class areas) where there is plenty of apartment stock AND prices are low for the working person to find housing (425-525) for a 1bd / 1ba turn over can be higher and finding quality tenants can take longer.
As a result you'll need to factor in turn over costs $75-150 a month per unit on top of maintenance. As well as vacancy that might be more like 12-16% instead of the typical 5-10%. Your mileage may vary.
These can mess up your "beautiful" cap rate
ALSO
Be mindful of debt service. A lot of players in the space will tell you don't buy lower cost properties with a mortgage but that puts it out of reach for many people.
I've found people that will do sort of creative financing to allow you to purchase 30-70k properties but because you can buy them for 10-20k. I've seen people get a few at once
If you do that the interest rates vary AND it's NOT likely a "blanket / portfolio" loan so you can quickly run up against the HUD limit of 10. Portfolio loans for amounts less than 750k total value and single entity costs less than 60k each will also come with a penalty interest rate as they are non conforming.
If you're in a transitioning market and cap rates are increasing but your particular building continues to increase rents, your property value may stay the same (because of increasing NOI) or slightly decrease.
Just to clarify "transitioning market and cap rates are increasing" means that prices are going down which likely occurs when the fundamentals of the market/local economy are getting worse. This very well result may result in some buying opportunities, but transitioning in this case means the local economy is changing for the worse as I read and understand it. If you meant something else, please clarify.