Capitalization rate, does it decrease?

Question

If I bought a property for 40k, ( purchase and rehab), and my Noi is 8k, my cap rate is 20%

Question?  If property value increases to 120k after 5 years, and my Noi is the same 8k, does my cap rate drop to 6 %?  Is cap rate dependent on the actual purchase price or the increase in equity over the years?

Daniel Peavey · Answer

My bad!!  It was Misprint!!  My Return on Investment was 20%!!

Basically, my question is over a 5 year period, how does one calculate ROI??

Great info, did not know Cap Rate only pertains to Residential units of 5 or more, or commercial properties!

Thanks

Immanuel Sibero · Answer

Well this is the issue I have with cap rate in this particular scenario. I instinctively think that Property B would be the one to sell or refi (as you apparently did also). There is actually a good reason for this and it's because property B is unlevered (i.e. all equity) so I know the yield is not efficient or optimized. But this goes against the notion that you mentioned in your earlier post that cap rate should be a good indicator to decide which one to sacrifice because it puts the properties on a level playing field without regard to equity. In this scenario, the cap rate analysis actually leads to a wrong decision precisely because it takes equity out of the equation. Although Property B has a higher cap rate, it is the right one to sacrifice because its yield is not as optimized as Proprety A (i.e. a leveraged 8CAP can easily yield 15%  while an unleveraged 10Cap would yield... well 10%).

Cheers... Immanuel

Lane Kawaoka · Answer

Cap rates are severely over estimated in most cases from brokers/sellers/syndicators. When I look for deals I don't really pay attention to it because expenses are always left out or income is inflated. Those top of the line items are again always manipulated and can throw the calculated cap +/-3.0. The only true way to determine is to get the trailing 12 month Profit and Loss Statement but at that point you have the information to underwrite it fully.On class B/C I have been using 6.5-7.5% reversion cap depending on market. For example 6.5 in Dallas whereas 7.5 in Gulfport MS.These days nothing is over 7.5% cap (unless its a truly off-market deal and a fringe deal under 60-units). I find the current prevailing caps from my friends who are apartment operators and ping them what they used on their last deal. Another way is to talk to a broker who has their pulse on the market and knows you need the number for underwriting purposes (and he is not selling you a deal).

Aaron K. · Answer

@Immanuel Sibero assuming each property was of equal value and one needed to be sold, then yes, however this probably wouldn't be the situation as I was thinking of money required for a down payment and in this specific scenario I'd just refinance property B.  But if just refinancing property B were not enough, I'd likely sell property A and refinance property B instead of just selling property B, of course this depends on property value and loan origination fees etc. to make a fully informed decision.

Immanuel Sibero · Answer

Well that's an interesting scenario. I haven't had the fortune to be in that situation but how would you pick the sacrificial lamb? Suppose you have property A with 8%Cap and 25%Equity and property B with 10%Cap and 100%Equity (owned outright). Would you get rid of the property A because it has the lower cap rate?

Cheers... Immanuel

Aaron K. · Answer

@Immanuel Sibero I suppose I thought of it more in the context of there was a new property to purchase and capital needed to be raised from refinance or sale, thus you would need to compare your own properties against one another, to determine which to sacrifice for lack of a better term.  In your context your solution works as well or better because you are making the decision for an individual property.

Immanuel Sibero · Answer

@Aaron K.

I can comment from my own situation since I’m going through this process. I have a rental that is now worth 2.5x with NOI staying the same since purchase (i.e. so cap rate based on purchase price has been the same which is 10%). This is very consistent with the scenario described by the OP. So my options are to SELL OUTRIGHT and redeploy or REFINANCE some cash out and deploy. How would I use cap rates to decide?

What I’m doing now is running Cash on Cash and IRR analysis on both scenarios (i.e. SELL OUTRIGHT vs. REFINANCE). And yes, this analysis requires me to assume exit at some point so I run different hold periods i.e. 10, 15, 20 years with assumed sale prices at disposition. This analysis helps me with:

• - Which option has higher yield/return
• - Whether or not I’m going to be cash flow positive
• - Comparison to other sector investments (i.e. stock/bond portfolio, mutual funds, etc.)

When it comes contrasting Cap Rate analysis vs. CoC/IRR analysis, I find:

• - The data you need to do cap rate analysis is already about 80% of the data you need to do a CoC/IRR analysis so might as well do the CoC/IRR.
• - After doing a cap rate analysis, I feel the need to do CoC/IRR anyway to verify the result of the cap rate analysis.
• - I still need to do CoC analysis to make sure I’m cash flow positive.

Now when you're getting into an investment initially and having to choose from a few similar properties I can see how you can use cap rate for comparison but when it comes to SFR's I'm not sure if cap rate is any better than the 1% rule (which is way simpler than cap rate).

Incidentally, I just noticed Grant Cardone just posted about how important CoC is to him and how CoC had kept him out of trouble throughout his career. :-)

Cheers... Immanuel

Aaron K. · Answer

@Immanuel Sibero wouldn't cap rate be an indicator as to which you should choose for a particular property either to sell or to refinance, in that way it is a level playing field that does not depend on how much equity there is in the property.

Daniel Peavey · Answer

thanks for insight!

Immanuel Sibero · Answer

I'm in that situation. I could care less about cap rate (especially if it's an SFR, which is what I have). Right now I'm considering selling and redeploy OR cash out refi and deploy. I guess I could calculate and recalculate cap rate every month but what for? It's irrelevant, I'm more interested in my Cash on Cash and/or IRR.

Cheers... Immanuel