Understanding Cap Rates and the impact they have on prices!

[Easton Hill]

One of my favorite parts of investment real estate is also one of the worst!

Investment real estate is valued through cap rates

You take the cap rate and then divide it by the true earnings of the property (NOI) to get the value

NOI = $100k / 0.04% = $2,500,000

Every dollar you add to the NOI generates $25 dollars in value

Every dollar you subtract from the NOI reduces value by $25 dollars

As an entrepreneur that's exciting because NOI is mostly in your control!

[Easton Hill]

@Pepper Bradford

Remember that cap rates are a "Lagging indicator" or rather a representation of a property's performance in the past. 

NOI / price = Cap rate
10,000/ 1,000,000 = 10% 

So as long as you can see the NOI & listed price of a property (or quickly calculate it) you can quickly find the cap rate. So just start looking at properties that are listed in your area and you can get a sense of what the current market is. 

To explain further, you can reframe cap rates as NOI multiples as well if that's more intuitive. 

5% cap rate = 20x NOI

10,000 NOI / 5% = 2,000,000

2,000,000 = 10,000 X 20 

5% caprate = 20x NOI

6% caprate = 16.66x NOI

7% caprate = 14.28x NOI

8% caprate = 12.5x NOI

9% caprate = 11.1x1NOI

10%caprate = 10 x NOI

So when you see a property sold for a 10 cap, you can just say "That buyer thinks that that property is worth 10 years of NOI or profits"

So are cap rates get lower the market is paying "more years of profits" and when cap rates get higher the market is paying "less years of profits" 

Typically the less risky the future is for a property the "more years of profits" an investor is willing to pay (aka a lower caprate) 

An apartment building in NYC manhattan will trade at 4% cap rates or 25 year of profits, whereas the exact same building in St. Louis might trade for 7% because investors feel more confident about the future of NYC than they do about St. Louis all else equal. The same building in a small rural town might trade for 10-12% because again the investors feel less confident about the future of that town and will only pay a certain 8-10 years of profit for it today. 

Remember the building is only as good as what it produces in cash flow. 

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Sorry to get long-winded, but I get really nerdy about this stuff!