All Forum Posts by: Immanuel Sibero

@Luke Davis

With the so many metrics thrown around on BP, some are straightforward some are not, and still others are often misunderstood (i.e. cap rate being the most misunderstood), it may help to first identify WHAT can be measured in a real estate investment and then look at HOW they are commonly measured.

The four sources of return in rental real estate (i.e. WHAT we want to measure):
1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings

Some examples of metrics used to measure return (i.e. HOW we measure):
- CoC (Cash on Cash) is a measure of net return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis.

- Equity Multiple (or ROI) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. Equity Multiple does NOT take into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- IRR (Internal Rate of Return) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. IRR takes into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- Cap Rate (Capitalization Rate) is a measure of how efficient a property generates NOI in relation to the property's cost/value. The problem with cap rate is NOI does not paint a complete picture of a property return (see the "four sources of rental real estate returns" above for a complete picture), so cap rate is a poor measure of return because it does not measure any one of the above source(s) of return. Cap rate, however, is commonly used as measure of value/risk.

IMO, cap rate does NOT belong here (when talking about performance measure). I include it because it is so commonly used by investors (incorrectly, I might add). Hope this helps.

Cheers... Immanuel

@Ryan Logue

I think you're looking into "cap rate" a little too much :-) I would focus less on cap rate.

"..is it better to buy below the average cap rate for the market, or above the cap rate for the given market?"

This one is easy. I'm assuming everything is held constant, all numbers are verified, the properties are the same quality, in the same quality market. When you buy below market cap rate you pay more than asking price. If there is good reason for this then the price you pay is the new market price for that property (i.e. you set a new cap rate). When you buy above market cap rate you pay less than asking price. A good reason for this could be you just got yourself a good deal or it's a declining market.

"I can even likely increase the NOI which will increase the Cap rate more. Yet people are telling me this too high of a cap rate and I should be hesitant. I don't understand it, can someone help..."

You should abandon this concept of making money by purchasing a property and "increasing cap rate". As you stated, increasing NOI will increase cap rate but then people say "too high a cap rate" is a bad thing. Hmmm… seems contradictory, isn't it? If you buy at 10CAP and pull out your tricks and increase cap rate to 15CAP, I'm guessing people would say it's a good thing, right? But what if you were able to increase cap rate to 25CAP? Would people say it's a bad thing because it's "too high a cap rate"? Where is the threshold where you go from good to bad? 19CAP? 21CAP? What's the formula to determine "too high a cap rate"?

This is the reason you should forget the concept of "increasing your cap rate". You already have the answer. You purchase a property and make it your goal to increase NOI. The higher the NOI the higher the value of the property. Who cares what cap rate does. No one is going to complain about your NOI being too high (i.e. "too high an NOI").

"On the flip side, with interest rates so low, does this also mean there is a risk for the value to decrease a bit if rates rise significantly. For example, if this $500k purchase price goes down to $475 market value with increased interest rates, then the cap rate increases and the investment was a poor choice."

Although they’re not strongly correlated, there is enough data to show that cap rate tracks the movement of interest rate (some say cap rate tracks the movement of 10-year TBill yield which influences interest rates in general). In turn, interest rates movements directly affect investors’ required ROR (i.e. rate or return) in that higher interest rates lead to increases in investors’ required rate of return and therefore drive down valuation of asset in general (including real estate). So I agree that should rates rise real estate values would trend down. At least this is the theory in general but know that we’re dealing with real estate where everything is local so there are of exceptions.

Your example of $500k at purchase and $475 current value (i.e. buying at lower cap rate) is not necessarily a poor choice. It’s not a poor choice if it was planned from the beginning. In the current environment of low interest rates and low cap rates, many conservative investors build into their underwriting to buy at lower cap and sell at higher cap. And, yep they still make money.

I also agree with another poster that there is something more about a property for sale at 10CAP when the prevailing market is at 7CAP. WHY would anyone sell below market when he can easily get market rate? Is he ignorant? Is he generous? Or maybe there is something about the property you do not know about?

Cheers... Immanuel

@Fran Arti

Forget the video, it is misleading when people (even very experienced investors) say a value add project is when you purchase a property, increase the cap rate, and then sell it for a profit. I wish they would stop saying that because it confuses a lot of people trying to understand cap rate. A classic value add project is when you purchase a property, increase the NOI, and then sell it for a profit. So your effort to add value is by doing something to NOI not doing something to cap rate. So what do you do with NOI? You increase it! How do you increase it? You increase revenue, OR decrease expenses, OR both, that's it!! So what do you with cap rate??? Well... Nothing! Who cares!

When I hear people say "cap rate", I pay attention to which cap rate they are referring to. Many investors (even syndicators) may not even realize which cap rate they're talking about. There is the "property" cap rate, then there is the "market" cap rate! The property cap rate is the one that many investors calculate every year by taking the NOI of their property and divide that by the original purchase price of the property (pretty useless, IMO). On the other hand the market cap rate is a measure of how much investors in a particular market are willing to pay for a particular type of property at a given time. Sometimes, you hear this market cap rate referred to as "market sentiment". It's a measure of how desirable/appealing the properties are to the investors in that particular market (think California).

If you refer to the chart above, I listed two kinds of cap rate (propCap Rate and mktCap Rate). propCap Rate is simply NOI/Purchase Price. mktCap Rate is, again, a measure of market sentiment and can only be obtained by talking to the local market experts (i.e. commercial bankers/brokers, property managers, etc). The point here is you don't calculate this cap rate! It is market driven and you have NO control over it. In the chart above, I'm assuming the "market" cap rate to stay the same at 5%.

So let's say you buy the property with $100,000 NOI in year one. You would have to pay $2M because NOI is $100,000 and market cap rate is 5%, in other words properties are trading at 5CAP (we will assume market cap rate stays at 5CAP). Let's say you're a syndicator with a bag full of tricks and are able to increase NOI to $150,000 in year 2 (wouldn't that be nice!). Well in year two you calculate your property cap rate to be $150,000/2,000,000 which equals to 7.5%. But remember the "market" cap rate has its own movements! It could stay the same at 5% (which I'm assuming here) or it could go higher or lower... again this depends on the market (i.e. market sentiment). In this example, if you were to sell the property, then you would likely sell it by taking your NOI divide it by the "market" cap rate - $150,000/5% = $3,000,000.

The above example is a classic example of value add! Now you could say I have increased my cap rate (i.e. propCap Rate) from 5.0% to 7.5% but it's highly misleading because people may be thinking "market" cap rate which in this example stays the same at 5% (5CAP). What I have really done is increasing my NOI, in fact I really don't care that much about my property cap rate (propCap Rate). I could take off that propCap Rate line in the chart above and everything would still make sense. Hope this helps.

Cheers... Immanuel

@Katie Koehler

Good question! There is a lot of misconceptions around cap rate. Just do a search on "cap rate" here on BP, you will get an idea.

The cap rate that you mentioned in your post is the individual property cap rate. It is really useless (as you found out). Yet a lot of investors (even experienced ones) use it as a performance metric but it really is not a performance metric (at least not a good one, IMO). It is even more of a farce to use an individual property cap rate to measure risk. That's why you can't get your head around it. You gave a good example of how a negotiated price will ultimately change the property cap rate and thus change the risk, which is a ludicrous concept.

The cap rate as a measure of risk that you read about here on BP really refers to the "market" cap rate. Even then, this "market" cap rate is more of a value metric than it is a risk metric. This "market" cap rate is the one you should understand. But before understanding this cap rate as a measure of risk, you should understand it as measure of value first (value and risk go together anyway). "Market" cap rate is a blended (estimate) cap rate based on all the cap rates of the comparable properties that had recently sold in a particular local market. When you're interested in a commercial property in a certain market, you would need to talk to the local brokers, lenders, property management, to get a "market" cap rate. Again this is a blended cap rate for the market, NOT an individual property cap rate (you haven't bought a property yet).

Let's say, by talking to some brokers you find out that the prevailing market cap rate is 5% which means there have been some similar properties that had recently sold at 5% cap rate on average. A market with 5% cap rate tells you that investors are willing to pay $20 for every dollar of NOI. So any comparable property in that particular market with NOI of $100,000 will be roughly valued at $2Mill. Another way of looking at it is investors are willing to pay 20x NOI in that market, this maybe because the local economic prospects are good and better demographics of people are moving in. This is why some experienced investors describe this cap rate as a general measure of market sentiment (how confident they feel about the local market outlook). The more confident the investor feel about a particular market the more they are willing to pay for NOI. If one investor decides he is very confident / bullish enough about the market he may bid up and offer 25x for NOI which translates to 4% cap rate. In this case cap rate is said to have compressed.

So how does all this relate to risk??? Well, in the same way you may find another market where the "market" cap rate is 20%. A market with 20% cap rate tells you that investors are willing to pay only $5 for every dollar of NOI. So any comparable property in that particular market with NOI of $100,000 will be roughly valued at only $500,000 (only 5x NOI). Why are investors only willing to pay 5x of NOI??? Because the market has worse demographics (i.e. low income), local economic outlook is rather bleak. This is the type of market where investors feel that the market is riskier to invest in (i.e. higher vacancies, turnovers, and riskier demographics).

To answer your specific question- 

Is individual property cap rate a reliable measure of risk? Don't even think about it.

Is market cap rate a reliable measure of risk? Not really.

Cheers... Immanuel

The four sources of return in real estate:

1. Cash flow

2. Loan paydown

3. Appreciation

4. Tax savings

You mentioned cash flow of 10% per year, so you're missing the other 3.

Cheers... Immanuel

Kevin,

It's not confusing, your understanding is correct. Looks like the OP got it backwards. Maybe it's a typo.

The OP's statement:

"Another telltale sign of overbidding is when you purchase a property at a higher cap rate than market cap rates."

is backwards. If you purchase a property at a higher cap rate than market cap rates, then you have NOT overbid... you just got yourself a good deal. If you pay at a lower cap rate than market then you might have overpaid OR you might just be setting a new trend. Again it may just be a typo on the OP's part.

Cheers... Immanuel

There is really no correct or incorrect formula. I think what you're quoting is a GRM valuation which is the number of years the property would take to pay for itself in gross rent received. This is a quick and crude valuation estimate and it's useful when you have other "very similar" properties that are sold recently to compare with. Otherwise it's not very useful.

The more common formula used in the "income" valuation is the cap rate method. This method calls for NOI (Net Operating Income as opposed to Yearly Income). However, since it is a triplex I would focus more on the "comps".

You didn't address my bigger question though. A CoC of 6% after leverage?? From your post (i.e. location is 15 Minutes from Downtown (state capital)) I can see that this might be a growth or appreciation play but absent any appreciation upside potential, are you willing to take on this risk for 6% ROI? There are quite a few syndicated multifamily investments that cash flow more than 6%, and it's practically passive (i.e someone else does the work).

Cheers... Immanuel

@Rae Bryant

When CoC approximate Cap Rate, the interest rate on the loan is relatively high compared to cap rate (the spread is minimal). It usually indicates -1. the loan is not working effectively as a leverage -2. The project is risky and I would require a compensating return such as a significant value appreciation potential.

Have you looked into recent sales of comparable properties (if any)? It's a triplex, so it's in that grey area of "comps" vs "income" valuation.

Cheers... Immanuel

In that case BP is probably one of the better forums to learn about cap rate. I encourage you to take the time and do a search on "cap rate" right there on BP, you won't be disappointed. Cap rate is one metric that's often misunderstood. On the one hand, Cap Rate is frequently used by investors as a performance measure (a poor choice at that, IMO) but on the other hand it is also used as a value/risk measure (a more appropriate use of it). Whether you use cap rate as a performance measure or a valuation measure, when utilized in a comparative analysis cap rate can be useful.

As a performance measure, a higher cap rate can indicate a better performing property than a similar property with a lower cap rate (so HIGHER cap rate is good). As a valuation measure, a lower cap rate can indicate a more desirable (therefore more valued) property than a similar property with a higher cap rate (so LOWER cap rate is good). Seems backwards... but that's exactly the source of misconceptions, misunderstandings surrounding cap rate.

Again, a search on "cap rate" on BP would give you lots to learn.

Cheers... Immanuel

@Anthony O. Porter

Hi Anthony! You are correct that NOI, Cap Rate valuations are commonly only used for 5 units or more. Single Family Houses, duplexes, triplexes and fourplexes are usually valued using recently sold comparable properties. But NOI and cap rate can be relevant when selling duplexes, triplexes, fourplexes (you would even see them on SFRs listings). This is because oftentimes the potential buyers are not just owner occupants but also investors who would be interested in the financial information.

If you understand (which you appear to) that SFRs, duplexes, triplexes, and fourplexes are commonly valued using comparables then you have an advantage! You know not to overpay just because the NOI and cap rate calculate to a higher value. You would stick to the "comps". This may even be a deliberate trick on the part of the agent to sell to a buyer who doesn't understand fully understand the difference in valuation of residential multifamily (2-4 unit) vs commercial multifamily (5+ unit).

Cheers... Immanuel