The Magical World Of Cap Rates

Capitalization rates: Can’t live with them, and you definitely can’t live without them. After all, they define return on investment and ultimately market value for income producing properties. Unfortunately, this is one area of Real Estate that is widely misunderstood. My goal is to bring some clarity to cap rates so that others can have a systematic approach to better understand values in their given market. I discussed income and expenses in a previous post. That’s a good start to understanding NOI, and from there, the cap rate can be found by a rather simple mathematical equation:

Net Operating Income (NOI) / Sales Price = Capitalization Rate

For example, if a property produces $10,000 in net income per year and sells for $200,000. That property’s cap rate is 5. Further, that means the $200,000 asset brings a 5% return on investment after all expenses are either paid or accounted for. That simple math equation is easy. The difficulty in understanding cap rates comes from the application of the math in the marketplace.

We need to understand that the main variables of the cap rate equation come from the market place: net income, market rent and sales price. Market rent is what a typical renter will pay to rent a given space. Sales price is what a buyer paid for a given property in that marketplace. A cap rate results from an interpretation of the income and expenses of the property divided by the price that property ultimately sells for.

“Interpretation of expenses” is where the discussion of cap rates gets confusing with investors, realtors, appraisers and other professionals in the industry. After all, expenses can easily be defined by an owner’s profit and loss statement or the schedule E on their tax return. The reason I say “interpretation” is because that is how it should be viewed and how it is viewed in the market place. Quite often an appraiser will calculate a different cap rate than what was reported by the realtor for a transaction due to a different interpretation of the expenses.

How often does a buyer just take an owner’s profit and loss statement (or their realtor's representation of the owner’s statement) at face value? Hopefully, the answer is never. Every buyer should have their own thought process as to the expenses required to adequately own and manage a real estate asset. For example, many owners self manage their own properties. However, not all buyers will self manage. Even if they did self manage, they should still be factoring in an allowance for property management. Appraisers factor this into their opinion of market value and buyers should as well. This is one example of an interpretation that can vary from person to person or property to property.

Therefore, I propose that each individual property has two effective cap rates: one from the owner’s perspective and one from the buyer’s perspective. Sellers and buyers rarely have the exact same thought process for a specific property. This doesn’t mean that sellers and buyers don’t ever agree, it just means that their interpretation of NOI, and consequently cap rate, typically differ.

If we are in a position where we are relying on cap rates to determine value, we should be using our own set of defined variables for the cap rate equation. If we are consistently applying the same methods to determine income and expenses, we will get consistent outputs of cap rates from the marketplace. When we do this, we get get most reliable and useful data as buyers and sellers of income producing properties.

This is how appraisers work. Appraisers use a consistent process of determining expenses and income. Using this consistent process results in a consistent determination of cap rates for individual properties in the market place. Once we have a data pool of consistently extracted cap rates from the market place, we can then reconcile that data to establish a cap rate to apply to a specific property.

As an investor, using expense ratios is an easy way to create a quick, easy and consistent process for analyzing expenses. This brings consistency to the equation and and still allow for quick analysis.

A recent conversation I had with another investor illustrates the importance of a standardized cap rate equation. They were interested in purchasing an older property located within a high demand location of Portland. This property had below market rents, deferred maintenance and an owner that did not utilize a property manager. This owner also completed most of his own maintenance tasks.

The investor that instigated this conversation with me made a comment along the lines of “The problem is he’s asking for a 4.5 cap on this older building with deferred maintenance. I don’t see how I can pay him a 4.5 cap and then pay all the costs associated with bringing these units up to market standards. I feel I need to offer him a 7 cap to get the desired rate of return”.

My response to him was that cap rates don’t necessarily vary by property. Cap rates are a market driven valuation factor. You don’t just say, “I know this neighborhood has cap rates in the 4 to 5 range, but I need to pay him a 7 cap in order to make a deal that works for us”. Instead, we needed to establish what price similar properties are selling for in the open market. Once we look at those similar buildings and apply consistent income and expense calculations to those properties, we can extract a definitive cap rate we can then apply to our subject property. We both agreed that this neighborhood was producing cap rates in the 4 to 5 range. Next I said, “If you improve the property as planned, will your rents increase?” His answer was yes. I then asked, “If you pay the seller a 4.5 cap on his current net income (using the seller’s current rents and the buyer’s estimation of expenses including allowances for management and capital reserves) of $81,000 ($1,800,000 purchase price) and put your estimated $150,000 of capital improvements into the building, immediately increasing the net income on the building by $20,000, would you be happy with the $444,444 increase in market value you created?” “Of course!” He replied.

The investor, if he so chooses, would ultimately be into the asset $1,950,000 (not including lost rent and incurred expenses while repositioning the asset) and the updated $101,000 of net income represents $2,244,444 in market value for the property using the same 4.5 cap rate he potentially purchased the building with. On top of that, they have now updated the building and re-leased it, reducing maintenance expenditures and lowering their vacancy rate for the short-term future. The asset then cash flows even better in the first couple years of ownership after the initial improvement of the asset. In the end, the investor realized he could indeed pay the seller close to what he was asking after looking at the equation in this manner. Paying the seller a 4.5 cap may not make sense, but he soon realized that offering a 7 cap ($1,157,142) on the property, as he considered, would be seen by the seller as a “low ball” offer.

The context missing from the investor’s original perspective was that the rents were so far below market that the cap rate the seller was asking for was close to a true reflection of market value. Because current rents are lower due to deferred maintenance, the seller can expect to fetch a cap rate close to market standards, and the investor can still acquire the property at price that allows upside in equity and cash flow.

In summary, I look at comparables and their “facts” with two perspectives in mind. There is a seller’s perspective in the transaction and a buyer’s perspective. If I see a building sell with below market rents and a cap rate much lower than the market bears, I typically come to the conclusion that the investor sees the potential for increased value through increased rents. If I see a building sell with a higher than normal cap rate it’s probably due to some sort of inflation in the reported NOI. Understanding all of the factors that come into one singular sale can bring significant clarity to that sale and how it relates to the marketplace.