Rental Property Investor · St Louis, MO · Member since 2010 · 317 posts · 72 votes
Why is the cap rate normally reserved for commercial real estate investing? Do I look like I don't know what I am talking about if I market a SFR or duplex and mention its cap rate?
"The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate."
The operative word being "income". SFR are based on comparable rather than a calculated value of cap rate from income. Why? Good question. This my be a good place to start reading:
Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
10y
Yes. CAP is used for commercial REI comparisons so thatyou can compare different types of commercial REI invetments. It allows you to compare returns on your investment between NNN, multi, storage, offices, strip malls, gas stations, etc...
Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
10y
Because the property valuation mechanics in non-income producing property are not based on income, and while SFR can be used as a rental, FHA, Fannie, and the wider secondary market doesn't think of them in this way.
When I buy an SFR for my own residence, I buy it because I like the location, I like the school district, I like the layout of the house. There are many other "personal" reasons why I like the house. The point is I would value the house according to how much I desire the house based on those personal reasons (i.e. note that many other potential buyers also desire the house based on their own personal reasons). Obviously the house will go to the highest bidder. The real estate professionals will then keep track of these prices and call them "comps". So for purposes of determining values, in this case cap rates are useless.
When I buy commercial real estate (i.e. apartment complexes) or many other businesses for that matter, I buy it to make money, not to live in it. So I don't care as much about school districts, locations, etc. as I care about how much money I will be making. So I won't be valuing this purchase based on "personal" reasons. Since my primary goal is to make money I will need to value this purchase somehow, that's where cap rates come in (along with some other commonly used valuation metrics like GRM, price/door, etc.)
There are more renters these days so many SFRs have been turned into rental houses which means "investors" are buying SFRs for investment purposes (i.e. to make money). So it is conceivable for these "investors" to consider cap rates in valuing the SFRs.
So,
"Do I look like I don't know what I am talking about if I market a SFR or duplex and mention its cap rate?"
It's not that you look like you don't know what you're talking about. If your potential buyer is an "investor" looking to add to his rental portfolio, he might well be interested in "cap rates". If your potential buyer is a retail buyer (for example first time homebuyer) then they probably won't have a clue what you're talking about.
Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes
10y
It depends in part who you are marketing to and how.
Traditionally cap rate is not used for 1-4 unit residential properties. There are people who will think you foolish to use it that way. Of course there are also people who will find it useful. The snobs that think it is stupid to use for SFH are in the commercial market and will not likely see your marketing anyway. They certainly aren't likely to be a buyer for your property. So does it really matter what they think.
Cap rate is simply a mathematical formula that is a measure of performance of a income producing property. I should point out cap rate is not the only measure of an income producing property. It is probably not the best measure of financial performance. However that formula can be applied to any property, if fact it can be used for just about any income producing investment.
PS for the record I wouldn't probably wouldn't bother putting in a cap rate when marketing a SFH even if it was intended for landlords.
Carrollton, TX · Member since 2015 · 415 posts · 371 votes
10y
I'm a newbie trying to learn and get into commercial/multi family investing. I found "cap rates" to be an integral part of commercial/multi family investing. After reading quite a few posts of newbies asking about cap rates and the more experienced explaining about cap rates, I sensed there is a lot of confusion out there.
I wish the real estate industry had been using cap multiple instead of cap rates.... cap multiple is simply cap rates stated another way (i.e. by flipping the formula):
Cap Multiple = (Value or Purchase Price) / NOI
Cap Rates = NOI / (Value or Purchase Price)
so a cap multiple of 10 is equivalent to cap rate of 10%.
The difference between the two is psychological (lol). It's easy to think of cap multiple in terms of "value", a cap multiple of 10 simply says I'm willing to pay 10x of your NOI. So it's truly an assertion of value. Cap rates, on the other hand, can easily lead people to think of "performance" because the formula smells so much like another commonly used metric called "yield" (i.e. NOI/Cost). No wonder many people resort to thinking of performance when talking about cap rates! The higher the cap rates the better the performance... which is not necessarily true. Cap rates are not a measure of performance, "yield" is.
Thanks for the replies. What I am taking away from this is that the purchase price is a function of the rents for commercial property, and the price I should be willing to pay for a commercial property can be "reverse engineered" using typical cap rates for an area and the NOI of a property. While a 1-4 unit place has a price that has more to do with the quality of school districts, curb appeal, etc. Is that right?
Thanks for the replies. What I am taking away from this is that the purchase price is a function of the rents for commercial property, and the price I should be willing to pay for a commercial property can be "reverse engineered" using typical cap rates for an area and the NOI of a property. While a 1-4 unit place has a price that has more to do with the quality of school districts, curb appeal, etc. Is that right?
That's really good! It's not all of it, but there's more to it. If you capitalize value on NOI this gives you market valuation. As you know, we don't want to buy anything at market, so the next intellectual step for you to make is to think about how to buy with equity...
Broker / Investor · Tewksbury, MA · Member since 2008 · 1k+ posts · 351 votes
10y
This is where i get confused about cap rates, there is no average cap rate for 1-4 family residences, there are just comps. I capitalize noi on each property my client and i visit at 10% to get a sense of where the list price is, if my client was not leveraging the property at all but buying it with all cash. 10% return is a good return. With that being said if you only knew the noi of a property you would need comps to find the cap rate. So in the end cap rate is a function of market trends at that particular time in that particular market. I am still trying to figure out how to use it to help my clients get a better handle on what they are buying. Any cap rate over 10% is considered more risky but you get more cashflow, any cap rate below 10% is not risky but you get less cash flow.
He means that you would buy it at a discount at the outset, thereby having equity in the property on the first day of ownership.
If you watched Good Fellas, you'll know the gangsters there had total equity in the booze and cigarettes they stole. They could sell those goods anyone for below market price and still make a hefty profit. :)
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
10y
From Rich H. "Any cap rate over 10% is considered more risky but you get more cashflow, any cap rate below 10% is not risky but you get less cash flow."
Not really, unlike securities, the cap rate is not an indicator of risk, but to operational performance. No two investors will have the same cap rate because each will have different costs of doing business or holding costs to the income generated.
When you have large homogeneous units, many similar dwellings, the more active a market the more efficient that market will be. In this case, we use the market approach comparing similar units sold within a given time frame. We have a large pool of residential units. The use of the property is also rather limited to residential use.
Commercial property is a less efficient, in a less active market, no two are significantly the same as with dwellings. The market approach is not as reliable due to the more unique nature of commercial properties in a less efficient market. The "income approach" as well as the "replacement or cost approach" become a better indicator of value.
The cap rate is a performance indicator and is used two ways, one to judge specific performance of an operation and secondly to compare with other similar operations. We can judge what has actually been done after the fact, at the end of a month or year, we know what our cap rate is for a single unit and we can judge our operation by comparing to other similar operations in the market.
Estimating a future or expected cap rate is a shot in the dark, a guess unless you have statistically valid population of units to compare one unit to. If one investor owns 100 homes with that pool of properties being under the same management, same market conditions, same risk assumptions and other aspects being similar then an estimate of a cap rate for one more unit becomes more valid or ascertainable. However, if that investor only has four other units, his pool of investments lacks the law of large numbers to support a valid assessment with respect to comparing performance. His "population" of units owned is too small.
I mentioned "limited use" with residential properties, the use will be as a living unit, either leased or held. Commercial properties can have multiple uses.
I'm not writing a book here, so I'll skip the owner occupied angles and speak to investment rentals.
One big difference that effects income is they type of commercial lease we can have, triple net or other variations and that may include gross or net income provisions of the tenant, for example, they may be on a triple net basis and when their gross income exceeds x dollars the rent may be increased.
The type of tenant also makes a difference, my property may be better suited for a clothing store rather than a hardware store. An office complex may be more profitable as medical offices or if you're down the street from the courthouse might be attorney offices, there are choices and options to be evaluated.
Finding the highest and best use is found by seeking the highest cap rate for a particular operation.
The highest and best use for residential properties is stuck, it's a residence!
For those who are financially savvy, with a dash of economics and statistics, trying to sell the a SFR boasting about cap rates might be laughable. Now, if you're selling a portfolio of 50 SFR's then we can talk cap rate.
You may have a commercial use for a SFR, but it's not a commercial property, it's residential and it's primary value will always be reflected in the market first, the other two approaches to value are secondary and (but) can influence the market value.
So, yes, the cap rate is rather meaningless in dwellings, especially when the are estimated. :)
Why is the cap rate normally reserved for commercial real estate investing? Do I look like I don't know what I am talking about if I market a SFR or duplex and mention its cap rate?
Paul, What exactly do you think a cap rate will do for you? If you try to express that I can show you how it accomplishes NOTHING.
I am interested in your last sentence about buying with equity, do you mean helocs?
No - not at all. When I say "buy with equity", I mean buy below intrinsic value. There are 2 kinds of investors in this world - those who capitalize market value and are happy, and those whose aim is always to over-perform the market. Simply capitalizing value doesn't get you there :)
Thanks for the replies. What I am taking away from this is that the purchase price is a function of the rents for commercial property, and the price I should be willing to pay for a commercial property can be "reverse engineered" using typical cap rates for an area and the NOI of a property. While a 1-4 unit place has a price that has more to do with the quality of school districts, curb appeal, etc. Is that right?
Yup, you hit the nail on the head.
For Commercial REI, Value = NOI/Cap Rate. Thus, knowing any two of those variables you can solve for the 3rd.
Why is the cap rate normally reserved for commercial real estate investing? Do I look like I don't know what I am talking about if I market a SFR or duplex and mention its cap rate?
Paul, What exactly do you think a cap rate will do for you? If you try to express that I can show you how it accomplishes NOTHING.
Bob, I replied to you today on another thread too. What will cap rate do for me? I hope I can use it as a tool to negotiate buying commercial properties.
In due diligence of buying a commercial property, I could look at the tax returns and verify NOI, then use cap rate, and "reverse engineer" a fair offer price.
Hypothetical: If the asking price of a building is $300K and the NOI is $15K, that's 5% cap rate I would achieve, not too good. The seller may have bought the property for $150K 10 years ago and boast in the listing of achieving a 10% cap rate. He's not lying about the cap rate, but that is his cap rate not mine. But if I buy for his price, I would get only 5%. For it to be worthwhile, I would need to negotiate it down. Maybe the seller is looking for a gullible newbie to buy his place, but I would at least know better, and make a fair offer. I hope my example makes sense!
Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
10y
Why cap rates for commercial?
1. Because there are companies that calculate them on sales in a consistent manner with information from both the buyer and seller. There is no residential equivalent. You need a cap rate comp to calculate value. No one has published a verifiable cap rate comp on BP for a residential property, ever!
2. Direct cap is a flawed method of valuation. Direct sales comparison is better but commercial properties are generally encumbered by long term leases that can be above and below market. If all commercial leases were required to adjust to market annually then direct cap would be dropped and the more accurate direct sales comparison would be used.
3. Commercial buildings are generally operated on a professional level and contract for services from professional companies. So generally operating expenses are not going to be determined by a brother in law that does some side work on your residential property.
4. Commercial investors do not try to make themselves look smarter than they are by trying to use terms that they do not understand.