What is your MINIMUM required Capitalization (Cap) Rate?
Specialist · Orange County, CA · Member since 2008 · 2k+ posts · 623 votes
Although I'm not a big fan of using the Capitalization (Cap) Rate to analyze a property, it is a number used by many investors as a quick one-dimensional metric. It is also one that is more commonly used in the commercial space.
Of course, investors have different subjective expectations of what a "good" or "minimum" cap rate is.
So I'm doing a quick poll via this post:
What is your MINIMUM required Capitalization (Cap) Rate?
Thought I put two cents in this thread, guess not.
I agree that Bob is going down the right path. as I mentioned recently in a similar thread comparing stocks to real estate, before your cap rate is viable you need to look at apples and apples, not apples and oranges.
If you take Chapter One of The Principles of Real Estate, you'll see that while real estate in different classes may be similar but no two parcels are identical. That means the risks are not identical. To obtain a fair cap rate you need to look at opportunity costs of alternative investments, being the same or nearly the same, that's very hard to do in real estate.
Your cap rate will never be the same as mine, my actual expenses won't be identical to yours, in fact, mine won't be the same every year. Our cost of money isn't the same, our opportunity costs are not the same, our NOI won't be the same, out tax position won't be the same and forced or market appreciation won't be same same.
A seller tries to sell historical income setting a price. That's like selling me a used car showing your costs to operate it with the maintenance you did or didn't do and then expect me to pay a price based on your past experience, the second hundred thousand miles won't be like the first hundred thousand miles. While this is apples and oranges to real estate, the theory is the same, in assuming my future experience will be like your historical performance.
Lenders and appraisers have more market information than investors and much of that is shared. An appraisal is an opinion of value as of a certain date, it's not the market value until a price as been obtained in an open market transaction. Past transaction show trends, not absolutes. An appraiser will not say the cap rate for this property must be 10%, they are more likely to say that a 10% cap rate is comparable to what other investors obtain for similar properties.
Your cap rate analysis is more of a psychological barrier that a true financial barrier for pro forma assumptions. Picking a number as your cap rate and then adjusting income and expenses to arrive at that number is useless. The market set the income and only actual expenses set operating costs, fine for looking in the rear view mirror once in awhile, but I have to see or understand what's ahead as what is applicable to me in the future to my desired profits.
I do want to see fixed costs of a current owner, some of them will be applicable and other expenses may not be. Current rents only gives me a picture as to the current day and the near future as leases expire. Beyond that I have to look at the market and management expertise to profit.
I consider estimated net operating income, I never consider the owner's cap rate or even try to guess at my future cap rate, it's irrelevant. When buying, consider net income, forced and market appreciation, tax implications, management requirements, debt service and known fixed costs.
If a property isn't a real pain to manage, pays for itself and doesn't eat any hay, has cash flow for operations, doesn't really cost you anything, then it's a good deal!
Cap rates are fine for liquid investments, inventory management, use of funds, allocations to equity, but not to real estate, at least until you get to very large numbers and can accurately identify use of cash and opportunity costs within the market.
But, many like playing with their financial calculators.... LOL! :)
Obviously, I was getting too deep.
It's 3:46 am and I'm having my coffee, I really like getting up and having to think, thank you.
LOL
Rule # 1. The cap rate is used to evaluate the investment of two or more similar properties, not dissimilar properties.
Rule # 2. In real estate, the cap rate is established in the market it is not a rate you assign based on your desires.
When you plug in a desired rate, you are looking at the yield requirement you demand. If income remains the same and you command a higher return, the price has to go down. If the price remains the same, to obtain a higher yield, the income must go up.
Seems to me that you guys (Bob and William) are mixing the two approaches, market cap rates and the investor's required yield.
It is rather confusing when an appraiser assigns a cap rate for the income approach. A good appraiser will assign that rate based on what other investors obtain on like properties, like a duplex. The appraiser's concern is finding an estimated market value, in that market, they are not assigning a yield requirement for the buyer.
The formula is the same but you're attempting to find two different solutions, one is market driven the other is an individual investor's requirement.....apples and oranges.
When you compare dissimilar properties, an 8 unit to a duplex, you are forcing an assigned rate required for that investor, you're not really comparing accurately the two properties against each other. A duplex and an 8 unit property are not in the same market, a SFD and MF.
Which is why I mentioned all that other stuff upstairs in this thread. Adjustments must be made to compare dissimilar properties, if they are so dissimilar or extremely different the comparison becomes invalid as the variables for your adjustments begin to influence the solution.
I just Goggled "capitalization rate" and found this off hand. First page I scanned seemed to be on the money, I guess by the title of the web address there are cap rate nerds, I don't know.......but here it is.
http://www.capitalizationrate.net/Capitalization-R...
Enjoy......popcorn anyone? :)
Seems to me that you guys (Bob and William) are mixing the two approaches, market cap rates and the investor's required yield.
Bill, I know I am not mixing the approaches. It just seems that I am having a hard time conveying my information to some people.
I tried to explain it (very basically) by comparing it to someone desiring to buy property at $100 per SF. Now if they are in a $150 per sf market then they are not really in the market. Now if they are in a $60 a sf market and buy at $100 then they overpay. but if you go into ANY market and KNOW what the price per sf OR the price ratio OF NOI then you will know market. Market sf $75 and you are buying 1000sf then $75000 is market value. Market cap rate is 8% and NOI is 20,000 then market value is $250,000. NOI of $21,300? then market value is $266,250.
Easy Peasy, although it is sometimes hard to get your head around it if you have learned it backwards and think it is like an interest rate.
@Account Closed
Yes, you're basically hitting on the 3 approaches to valuation, cost, income and market. You also left out a lot, depreciation and condition to the cost approach, but I agree on your applications, the trick is, which approach is best relied upon?
Wow, you're up early if you're in the land of Ua Mau Ke Ea O Ka Aina I Ka Pona, (The life of the Land is perpetuated in righteousness) LOL.......heck no I didn't know that, I looked t up just for you.... :)
@Bill Gulley, it's not even 1 am here but I need to be up in 3 hours.
Mahalo and Aloha.
Instead of putting a specific number on a desired CAP rate it would be better to say your desired rate is 1 point above market average.
Say your market average is 6%, your desired rate would be 7%. Once you find a property you like and run the numbers your can negotiate to your desired CAP rate.
which are third party companies which sell NOI and how reliable are these companies
The last property I bought has a cap rate of zere. Or negative. However, I expect to be able to sell it for twice what I bought it for after I add some value.
Can you show us the calculations that resulted is a zero or negative cap rate?
@Account Closed okay you seem to know capitlization rate well. So tell me this im investing in a triplex, has a good NOI, good cash flow, decent neighborhood that is appreiciating. I put the numbers into bigger pockers calcular and I got a Capitlization rate of 6.5%. Im a bit confused, do I care about this number given my property is only a triplex and not a commercial(Espiecially if all other variables seem to be good) or should I care and if so how would I go about tackling this.
Thank you for your time. Im hoping to close a deal this week so your help is greatly appreciated!
My minimum is 10% and my market avg is about 8%
@Account Closed okay you seem to know capitlization rate well. So tell me this im in vesting in a triplex, has a good NOI, good cash flow, decent neighborhood that is appreiciating. I put the numbers into bigger pockers calcular and I got a Capitlization rate of 6.5%. Im a bit confused, do I care about this number given my property is only a triplex and not a commercial(Espiecially if all other variables seem to be good) or should I care and if so how would I go about tackling this.
Thank you for your time. Im hoping to close a deal this week so your help is greatly appreciated!
A cap rate comes from a closed sale. That is the main value of a cap rate is that it is the result of someone ACTUALLY looking at a NOI and putting their hard earned bucks into the deal. Your 6.5% is just a "what if" number that means NOTHING. So lets say you BUY at 6.5% then YOU have created a cap rate comp. But since you did not look for market cap rate comps you did not know that the market was 8.5% and you over paid. Now your comp will be the talk of the market trying to figger out what was the deal but it will quickly be determined that you got scammed and your cap rate comp will be excluded from consideration.
@Account Closed Thanks. I just watched a Podcast(Episode 61) with Ben Leboyvich and Brandon Turner. They discussed that capitilization rate is useless for fourplexes and anything smaller because these properties are not valued by there income but rather through local comps. They say capitalization rate is more a term for commercial products as they are judged by NOI. Judging from what your saying this is not entirely the case?
A cap rate is only used if you have reliable analyzed closed sales on the property type you are buying. There is NO source for those in most residential properties.
AND, the income approach is a method of determining market value. The best way to determine market value is by direct sales comparison. If you have a commercial building with market rents and sales of commercial buildings with market rents you would use sales comps just like with residential.
BUT most commercial properties are encumbered with long term leases at above or below market rents so you have to value the NOI through the capitalization process. This is not as accurate as the direct sales comparison process so it is funny that so many residential people want to use this less accurate process because they think it makes them look smarter than they are.