Capitalization rate question

2 Replies

Hello everyone, I am a new investor from south Louisiana. I have researched articles about cap rates but was wondering if someone could give it to me in layman's terms with specific examples and explanations of how they affect the overall evalutation when trying to figure out whether or not to buy the property. Any information would be greatly appreciated. Thanks in advance.

John

John,

I'll give you an overview: Cap rate = NOI/Purchase price. Essentially this tells you the return you will earn if you buy this property un-levered (no debt/all cash) and make no changes to the property. If we flip this equation around we can also determine a potential purchase price as NOI/Cap rate = purchase price.

This cap rate must be supported by transactions in the market. So for example if you're looking to buy an apartment in a B class area, talk to brokers and see what other B-class apartments in that area have traded at. If it's an 8% cap, you can take that 8% cap rate and apply it to the year 1 NOI of the property you are buying to determine a purchase price. So if that property makes $100,000 in NOI we can determine a value:

NOI/Cap rate= purchase price --> $100,000/8% = $1,250,000 should be what you would be willing to pay

Commercial properties are great because they are all based on the NOI and cap rates. So if you take that same property and are able to increase NOI (by lowering Operating Expenses or increasing rents) by $50,000, you have created $625,000 in value! ($50,000/8%=$625,000). Many times investors will do this by managing better or making capital expenditures that justify charging higher rents.

Finally, it's important to remember market cap rates can change. Right now apartment cap rates are at basically historic lows, so although cap rates could be at a 8% in a market, it could be 10% in 5-years (or 5%...if I knew, I'd be a millionaire at 22).

Does this make sense?

It sure does. Thank you for clearing that up for me.

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