Know Thy Cap Rate: The illusive obvious.

For some reason cap rates seem to be the most misunderstood term (ratio actually) in all of real estate. I often get asked by new investors what a cap rate is and what does it mean. I never get asked the same question by commercial and multifamily brokers but often find out (in a roundabout sort of way) that many have no clue either.

So I hope to tackle this issue once and for all and if I am successful, this should be the most read blog post on the internet for new investors (brokers you can read it too; don’t worry we wont tell).

So first of all the definition: Cap rate is short for capitalization rate; which means an indirect measurement on how fast the income produced by the property can repay the amount that was invested (assuming you paid cash for the property).

In other words, if you purchased a $1,000,000 asset with no loans that produced $100,000 in Net Operating Income (All income less all expenses = NOI) then the cap rate would be 10; meaning you would get 10% of your investment back each year. Therefore 10 years is the rate in which the property would "capitalize" itself.

$100,000 / $1,000,000 = 0.10 = 10%

Cap rate would also be your rate of return on investment assuming you had no closing costs and had no debt on the property.

Here are some basic formulas. Memorize them. 

Cap Rate = NOI / Value

NOI = Price x Cap Rate

Value = NOI / Cap Rate

Learn it. Know it. Live it!

So what does this all mean? and a better question might be, how can we as investors (and even wholesalers) use this information to our benefit?

Since most apartment buyers do not buy their properties all cash but rather employ the use of some kind of financing, it is important to realize that the cap rate is commonly used in commercial and multifamily assets in the same way that “comps” (price comparisons) are used in a single family sale.

How do you value a single family house? You find two or three like-and-kind homes with similar square footage with similar condition in a similar location and you make calculated assumption that if they sold for a certain price that your similar property should too. Then you make slight adjustments to your valuation according to any minor differences in your subject property (“well mine has fresh paint and carpet”, or “this one’s lot is slightly bigger”, or in a “better location”, etc, so I’ll add a little value to the price tag).

You will use the cap rate in the same way. You find two or three (or more) like-and-kind apartment buildings with similar square footage or unit count, with similar condition of repair, and in a similar location and you make calculated assumption that if they sold for a certain cap rate that your similar property should too.

Another thing to understand about cap rate is they are also a measure of risk.

Higher risk markets will have higher cap rates: Investors want a better return for a higher risk.

Low risk markets will have lower cap rates: Investors can settle for a lower cap rate if there is little chance they can lose.

So when I hear “guru’s” teach that someone should only look for 10 cap properties that’s like telling a new investor that they should only look for $90,000 houses. A 10 cap is relevant to the market like a $90,000 house is relevant to the market.

A $90,000 house in Beverly Hills would basically be free.

A $90,000 house in Detroit would be foolish.

Imagine calling a broker in Beverly Hills and saying “Hi, I just graduated from a seminar and I want to make offers on all the $90,000 houses in Beverly Hills”. You would not be taken very seriously. In fact, you would be laughed at.

On the other hand, if you went to Detroit and said you were looking for $90,000 homes they would flood you with everything on the market… and call you a sucker.

Beverly Hills has so much demand there is not much risk of houses becoming worth $90k.

Detroit on the other hand has so much risk that investors would not be willing to pay $90k for a house.

This is exactly the same thing for apartments.

By announcing to the world you only want to buy 10 cap properties you are saying “I like high risk markets”.

By going to low risk markets like Los Angeles or San Diego or New York (vacancy is never an issue in these markets as long as you manage the building some-what effectively) and ask a listing broker for a 10 cap you will make yourself look ridiculous.

It’s the same thing.

But let’s not get confused by this. Would I buy a 10 cap property in LA? Absolutely! But that would not be market value. It would be a deep discount. And I specialize in getting deep discounts on real estate.

So how do we use the cap rate in the real world?

The first thing you want to do when you enter a market is find out what the Market Cap is; what are real buyers willing to pay for the amount of risk that exists in this market?

If you are looking for a 20 unit building in a certain area, what are the general cap rates that similar like-and-kind properties have recently sold for? Is it a five cap? Seven cap? Ten cap?

The answer to this question will also be a tell on what kind of market you are dealing in; Higher cap rates mean your purchase price is cheaper; Sellers are willing to sell their properties cheaper when they know there is a higher risk to accommodate for.

So let’s say you go into a market and find that five buildings with unit counts between 18 and 30 have recently sold (within the last year) for 7.8; 7.9; 8; 8.1; and 8.2 cap rates.

You could conclude that this would be about an eight cap market.

Let's say you find a building for sale and it produces a $70,000 in NOI (Net Operating Income).

Is $1,000,000 a good price? That would be a 7 cap.

Is $875,000 a good price? (8 cap).

What if you were able to negotiate an $823,000 price? That would be an 8.5 cap. Do you think someone in the market would buy that asset from you on assignment at an 8 cap? The market says that somebody would.

Do you suddenly see how cap rates are relative?

Can you now understand how you can do very well by simply playing the margins on cap rates?

Know your Market Cap.