What is a cap rate and why are they important ?

92 Replies

Originally posted by @Pete Harper :

@Rob Massopust

I have not seen GRM used in a long time. You see it mentioned in some of the older real estate investing books from the ‘80s. I'm curious if anyone is currently using it to value SFH and small MF. What in your opinion is a "good" GRM?

I guess the 1% rule is a crude version of GRM. 1% rule ~ 83 GRM.

I like GRM to ballpark plexes. Its my favorite initial analysis metric.

When a seller calls me I can give them a quick multiple range of monthly rent I'd be a buyer at. I realize GRM is annual, but monthly is easier for sellers (and me) to compute quickly. Theyll often say hold on a sec and get their calculator out.

I'm also old school and read the 80s books.  Maybe that's part of it. LOL.  Perfectly fine to use old strategies when your youngest plex seller was 63.  

As far as cap rates go, I like to know the market cap of my commercial assets and of select asset types Im interested in in my markets, but I don't use it a ton. When potentially large expenditures needed like capital improvements are excluded from NOI, the accuracy of listed cap rates of buildings for sale are always suspect. But I do figure true and pro forma if under contract to purchase.

 

Cap rate is just one of many metrics. Understand them all, but don't get stuck on any one. None of them are perfect, in and of themselves. They are also subject to manipulation by brokers/sellers. 

There's a book called "What every Real Estate investor needs to know about cashflow...and 36 other key financial measures" by Frank Gallinelli. It's a fast and easy crash course in plain english that will shed a comprehensive light in one stop. 

@Joseph ODonovan

I haven't dealt with cap rate before but am now in the middle of my first commercial deal. Cap rate is one of the main things that lenders ask and I had to do some googling and asking around to figure that out (well somewhat ;-). If my offer is accepted, I actually am going to evaluate the property on the 1% and will be paying mostly cash with the balance being owner contract... So luckily i wont have to jump through all the lender hoops and cap rates around commercial properties.

1% rule is easy math for me... Just going to stick with that for now regardless of what i am buying.

Cap rate matters even for SFRs. For example, if current interest rate is 3.5%,  I know that for a property in a decent city with cap rate above 5%, it may worth to invest, while it may not worth to invest (or too risky)  for a  property with just 3% cap rate.  I also know that if my property's cap rate reduces from 10 to 3 and it is located not in a great city, it may not worth to  hold and may be a good time to get rid of it and use the fund else where.  Cap rate is still an important number  to decide whether it is a positive leverage or negative leverage, and it is still one of the most important ratio for me to make my investment decision,  even for SFRs.

  

Originally posted by @John Erlanger :
Originally posted by @Jenning Yu:

Cap rate matters even for SFRs. For example, if current interest rate is 3.5%,  I know that for a property in a decent city with cap rate above 5%, it may worth to invest, while it may not worth to invest (or too risky)  for a  property with just 3% cap rate.  I also know that if my property's cap rate reduces from 10 to 3 and it is located not in a great city, it may not worth to  hold and may be a good time to get rid of it and use the fund else where.  Cap rate is still an important number  to decide whether it is a positive leverage or negative leverage, and it is still one of the most important ratio for me to make my investment decision,  even for SFRs.

  

Nah, direct capitalization formula is V=i/r. You may be able to determine NOI on a SFR but where would you get the r? Without the r you are wasting your time.

 Are you saying we must know cap rate first before we buy any single family? I doubt that.

@Isacc Lightbourn

Congratulations on working towards your college degree.  And hopefully starting to house hack after you graduate.  Although I did learn technical thought processes going through college (Accounting), the main thing I learned of value was there are different approaches and perceptions of the same concept.  Sometimes Perception or Reality don't matter, your just wanting to a make a good deal.

If you do get into real estate you will get into Cap rates and also Cash on Cash metrics.  Keep this in mind, I the seller am probably telling you the buyer the metric.  You have to both trust both of us have the same concept on how the metric is derived and also if we used the same info.  Basically don't trust me as the seller, you need to validate.

I don't use either metric, but then again I mainly do developing.  I worry about collateralization and cash flow.  How much do I have to put down up front for a loan.  I shoot for a loan with a 20 to 25 year amortization.  An operation with an 8 to 12 year payback.  Thus I am cash flow positive and if trouble hits, I have some slack; or I pay the loan off early.  Remember you make your money up front in your decision, its hard to make it later.

Back to Cap rates.  Use them as a guide.  Determine your metric.  Just because a house falls outside of your metric you still might pursue it.  Example:

Exact same neighborhood, exact same price, exact same CAP rate.

House 1:  At the end of a T intersection, on normal lot. 2 BR, 1 bath

House 2:  Corner lot, 2 BR, 1 Bath

Even though the cap rates are the same, you pick house two, because it has greater resale value, and might have the expansion potential with land to a 3 BR, 2 bath.

Now someone will say, but they should not have the same Cap rate.  Hey the two Realtors calculated it.  Whether they did it correctly or not, you have to see past that.

Luckily you will work through this.  Do about 10 business calcs on you House Hack, before you ever get involved.  Have someone talk them through with you.  Join a local group.  The next 10 years of your career will be the best time ever, even though your hanging by a thread sometimes.  Step to the side every once in a while and pat your back for your successes and for your losses, say ouch, but great learning event.  Enjoy the ride.

I do Self Storage, so I stay away from houses.  In 10 years, call me and say hey, the 85 year old guy with the 35 rentals, does he want to sale?  Hopefully he is still alive. By then you should be able to take on an acquisition like that.  That is how much you will grow in 10 years.

Start small and make your Big Mistakes Early.

@John Erlanger

@Isacc Lightbourn

Folks this thread is started by Mr Lightbourn for his edification.  Not for our personal truisms.

Mr Erlanger please summarize to Mr Lightbourn at his stage of the game how to use Cap rate, from your perspective.  I believe your view is to not use them as all for House Hacking.  Just tell him that.  He either can delve into the calculation further, or he can take your advice and move on to the next aspect of valuation.  Which you can guide him down.

He is still in college and yet to graduate.  When he gets out on the Real estate side, he will try to do House Hacking.

Mr Lightbourn, my summary is this from above.  There are normal metrics used in any business field.  Use them as a base, but look beyond those at the value of the property.  Me personally I don't use Cap rate, even though it is used often in the Self Storage field.  I also don't use Cash over Cash.  I have already stated the metrics by which we run our operations.

Good luck in your endeavors.

I did not expect so many replies! I read every single on of them and all the different definitions and debates really gave me the best perspective on it. Thank you all so much! I love gaining new knowledge! I can now discuss this topic with confidence thanks to all of you!

@John Erlanger I've read comments here.  I am new but I've done a few apartment deals and business acquisitions using what you would consider "false" math and numbers so I'm curious to understand this better:

Ohio $1,000,000 @ $100,000 NOI = 10% cap rate

CA $2,000,000 @ $100,000 NOI = 5% cap rate

From my understanding yes I would say that the seller in Ohio is in fact getting about half of what the CA owner is getting and that is for several reasons regarding market, trends, appreciation, etc. With businesses the NOI or multiplier and value can be different in different areas and industries as well. The "return" is of course dependent on many things including how well run the property and know your stuff.

But the cap rate (assuming it is honestly calculated) does give you a rough idea of that, am I missing something major?  If so I can give a few examples because we do value adds to commercial properties and apartments and businesses regularly and everybody operates and uses/profits/refinances based on the cap rate.  It isn't everything but in my experience most lenders and money people treat it very seriously.  

Thanks is advance explaining.

I couldn't read all these comments... Simply put cap rates are commonly used for properties larger than 4 units. 

it is based on the assumption you paid cash for the property. NO LOAN. For example:

purchase price: 1,000,000

profit after all expenses: 100,000

cap rate =10%

it can be used as a tool for you to get an estimate of a larger multifamily value. Just do it backwards, 

ask a broker for the market cap rate in the area of the property

find out how much they claim is their profit.

reverse the equation and you will have the estimated price of the property.



@Isacc Lightbourn plenty of members have already posted responses, so all I'll add is that a cap rate is a "moment in time" valuation that is only as good as the data used to plug into the calculation. Often I see investors use cap rate as the metric by which they pair one investment over another, or assign a future cap rate to a future disposition of an asset. This is fine for general planning purposes, but often varies greatly from reality.

  • 1. What if the income increases more slowly than anticipated?
  • 2. What is the market is trading at a different value on the disposition date?
  • 3. What if the expenses aren't recaptured and increase/decrease at the disposition date?

All of the above factor into what the actual NOI is of an investment at one moment in time, and everything beyond that one moment is theoretical and proforma.