All Forum Posts by: Immanuel Sibero

@David Jenkins

Others have shown the formula to calculate cap rate. But maybe it helps to look at cap rate conceptually. Since you're a realtor, it may be helpful to draw an analogy of residential homes and apartment complexes. 

In general cap rate is to a apartment/commercial property what price/sqft is to a residential home. When you value a home you check on recent sales of other homes nearby and roughly use the price/sqft of the sold homes to determine the value the home you're interested in. You would take the price/sqft of the sold homes and multiply it by the sqft of the home you're interested in to calculate the value (i.e. offer price). This price/sqft metric is frequently referred to as "Comps".

In much the same way, you value an apartment complex by checking on recent sales of other apartment complexes nearby. The problem with apartments is that price/sqft metric is not a fair metric to calculate value, so the industry came up with another metric that is more fair... meet "Cap Rate". So in valuing apartment, instead of taking price/sqft of recently sold apartments and multiply it by the sqft of the apartment you're interested in, you would take the cap rate of the recently sold apartments and divide it into the NOI of the apartment you're interested in to calculate the value (i.e. offer price). This cap rate metric is frequently referred to as simply "Cap Rate".

The point is, the process of valuing a home or an apartment is conceptually the same, that is by using "Comps" from recent sales of similar properties. You use price/sqft comp for homes and you use cap rate comp for apartments.

I would also do a search on "cap rate" right here on Biggerpockets, you would find a wealth of information. There is a lot of misconceptions surrounding cap rates so beware of clueless posters.

Cheers... Immanuel

@Daniel Y.

I think you have an excellent read on the DFW market. The path of progress in DFW is north. They're still building A class apartments north of Dallas. Some of the apartment syndicators are seeing that new supply of A class apartments is finally catching up with demand, if not surpassing it already. So there is the added risk in A class apartment investing.

I got into real estate investing 2 yrs ago with rental houses but wish I had gotten in real estate 5 or 6 years ago. For the past year I have been focusing on the B/C apartments in DFW and they are hot. I guess the millennials are starting to leave their parents' home but still can not afford a house so they end up in apartments :-) The market cap rates for B/C apartments are about consistent with  your findings. However, the syndicators are still able to buy at 8% (which is in line with your thinking) by building relationships with brokers and getting their pocket listings. Even then these deals are rare and usually have some element of distress or urgency on the sellers' part. Competition is cutthroat as there are a lot of local syndicators here in DFW, and that's not counting high interest from out of state (i.e. You, haha). Many syndicators have turned their attention to secondary areas - Waco, Denton, Wichita Falls, even Oklahoma City.

My strategy right now is to learn the industry and the market as much as I can. I'm building relationships with lenders and brokers. I invested as a passive with a local syndicator who is also mentoring me on underwriting. I'm also keeping dry powder so when the market makes a turn I would have a clue on what to do... haha. But most of all, I'm just having the time of my life, it's an exciting time.

By the way, I have two new neighbors from CA and also notice increasing number of earthquakes in TX. Things must be pretty bad in CA even the earthquakes are moving to TX.... :-)

All the best... Immanuel

@Theresa Nelutescu

No, I'm not saying you should use 4.13% interest rate. Interest rate is one of your constraints (i.e. it's your cost of capital), you have no control over it. You should use whatever interest rate you expect to get. You are correct that interest rate is generally higher in commercial properties. From @Daniel Y. post above, 5% may be too low. 

What I'm saying is if your cost of capital (i.e. interest rate) is 5% or even higher, investing in a property with 4.13% cap rate doesn't make sense... unless the property has significant upside potential (i.e. high rent growth and/or appreciation). Without any kind of growth, there are safer mutual funds that will give you better returns.

@Daniel Y.

How is your Dallas/Ft Worth, TX area research coming? :-)   I'm a newbie just getting into apartment investing. Would love to compare notes...

Immanuel

@Theresa Nelutescu

This is a good case study of the relationship between cap rate/interest rate spread and how it impacts cash flow (CoC). You offered a scenario where cap rate is 4.13% and another where cap rate is 5.72%. Financing either scenario with 5% loan is just too expensive.

Why would you finance a 4.13% cap rate with a 5% loan? The purpose of leverage is to get a return higher than the cap rate by financing the project at much lower interest rate. Financing a 4.13% cap rate with 5% interest loan is "reverse" leverage where the bank takes a bigger chunk of the return than you do. Using your assumptions, your CoC goes negative at 65% leverage.

In the other scenario of 5.72% cap rate, you would benefit from leverage somewhat but the spread is too thin where at certain debt/cost ratio, CoC would easily go negative on you (i.e. around 88% leverage). What if you need to refinance in 5 years at an even higher rate?

There are parts of the US where I would still look at this project - areas where I'm almost certain there is strong and above average growth of income or above average appreciation or BOTH. But this requires a complete analysis throughout the investment horizon (i.e. IRR analysis). Without the above growth assumptions, I would be overpaying for this investment. You just don't want to overpay - you lose money by overpaying for a crappy property, you also lose money by overpaying for an excellent property.

All the best... Immanuel

@James C.

It doesn't make sense that a higher cap rate suggests stronger income, if anything it suggests weaker value/price. It makes more sense to me that cap rate is a measure of risk whereby the higher the property cap rate the riskier it is. The riskier the property the less desirable it is, therefore the weaker (lower) the value. But we're starting to get off topic...

Immanuel

@James C.

So the higher the property cap rate the better?

Immanuel

@Erica Seydoux

@Chris Grenzig has shown you the industry norms to calculate the market value of a commercial property. But there is really no way to verify it. Potential buyers and sellers may value a particular property differently based on their expectations, preferences, risk tolerance, etc.

Much like beauty is in the eyes of the beholder, real estate value is in the eyes of the beerholder...

Immanuel

@Simon Ghandil

@Account Closed

Following this thread, I'm curious as well, this is disturbing... 

@Franky Aikens

It would help a lot to see the detail of your calculation. Let's look at some definitions in general terms:

Cap rate = NOI/Purchase(Value)

Cash flow = NOI - Debt payments - Cap expenditures

So according to the formulas above, a high cap rate with low or negative cash flow can result from high NOI and also high debt payments and high capital expenditures. So it's likely that you're being very conservative with your capital expenditures or, if the project is financed, high interest rate and shorter amortization. So yes it is possible to have high cap rate and negative cash flow.

@Franco Li

How can you tell if there is property appreciation? If anything, in areas where there is a lot of property appreciation the cap rate is excessively compressed (i.e. CA, NY). Besides, property appreciation is not a factor in the calculation of cap rate nor cash flow.

Immanuel