All Forum Posts by: Immanuel Sibero

A search of "cap rate" right here on BP will show the misconceptions surrounding cap rate.

IMO, context is important here. When someone mentions "cap rate" in a single family rental investment scenario, there would be at least one post stating that cap rate is totally irrelevant. There are two contexts where "cap rate" is frequently thrown in - one is "performance" and the other is "valuation". When cap rate is used as a performance metric (i.e. NOI/Cost), I don't know about you but I see the use and the relevance in comparing rental house A vs. rental house B. If house A has a higher cap rate then house B, then house A performs better than house B. Stated another way, house A produces more NOI for a given Cost (i.e. more efficient in squeezing NOI out of Cost). Now, within the context of "valuation" then YES... cap rate is irrelevant in rental houses because rental houses are valued using recently sold comparable houses where some of them are not even rental houses (i.e. they do not even generate NOI).

To say that "cap rate" is totally irrelevant in SFR's is ignoring the fact that some (actually way too MANY) investors use the term cap rate within the "performance" context.

Now if we could have a different name for "cap rate" as it is used within the "performance" context... oh let's say "operating yield"?? Maybe this will help eliminate all these misconceptions?? After all the formula of Operating Yield is NOI/Cost... (hmm, where have I seen THAT before?)

Cheers... Immanuel

@Jordan Ghasemi

I agree with IRR being an alternative to CoC, in fact it is a much better alternative.

The four sources of return in rental real estate:

1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings

- 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

- 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

- Cap Rate (Capitalization Rate) is a annual 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. Cap rate, however, is commonly used a measure of value/risk.

Cheers... Immanuel

Just like in single family homes, the so called "comps" of apartments determine market cap rate. Let's say I was considering to purchase a 50-unit apartment in a certain market, I would first be very interested in the "market" cap rate. This market cap rate is the average of cap rates of recently sold comparable apartments so naturally I expect to pay that cap rate. Just like in single family homes, I would contact local brokers, lenders to get the comps. So the average market cap rate, in theory, is NOT subjective because it's calculated based on actual recent transactions. It's a gauge of how prices have been based on recent transactions (i.e. as indicated before, it is the prevailing investors' sentiment). 

Let's say according to the local brokers the last few apartments were sold at an average of 10% cap rate. And I also obtained the T12 of the property i'm considering purchasing (i.e. let's say NOI is $1Mill). I now can estimate that the market is probably valuing the 50-unit apartment I'm interested in at around $10Mill (i.e. $1Mill NOI/ 10% market cap rate).

In a way, the mechanics of valuing apartments are conceptually the same as single family homes. It's all about the "comparables". The difference is that in single family home valuation you're comping price/sqft of recently sold homes, whereas in apartment valuation you're comping cap rates of recently sold apartments. But in both cases you're "comping" just the same.

Another notable difference between single family home valuation and apartment valuation is in the availability of data. Comping a single family home is a lot easier, more objective, more accurate because there is a complete and centralized repository of historical data (i.e. the MLS). There is nothing like that in apartments which makes the valuation process less efficient and probably more subjective.

Cheers... Immanuel

@Sylvia B.

That's very perceptive of you. Yes you are correct about the statement "The market dictates the cap rate, and the cap rate is based on the NOI." not making sense because it doesn't. That statement is comprised of two paragraphs that contradict one another.

The formulas you quoted from the article:

• NOI / Cap Rate = Property Value
• Property Value x Cap Rate = NOI
• NOI / Property Value = Cap Rate

need further explanations. As they are written, those formulas are logically circular (i.e. Value depends on cap rate and cap rate somehow depends on value also. It's like watching a dog chase its own tail)

There are two types of cap rates - the "property" cap rate and the "market" cap rate. The "property" cap rate is calculated by taking the NOI divided by the value(usually cost) of the property in question. So this type of cap rate differs from property to property. The "market" cap rate is NOT calculated, it is determined by the market (as the name suggests). This is the cap rate that you obtain from the market participants i.e. commercial brokers, lenders, investors, etc. This cap rate is really a measure of investors sentiment towards the local real estate when it comes to their expectations, outlook, etc. In other words, it's a measure of how desirable the investors think the properties are in a specific market. For example, the more investors like the economic prospects of a particular market the more they are willing to pay and the lower the "market" cap rate goes. THIS cap rate is the cap rate that should be used when it comes to valuing a property NOT the "property" cap rate that the article seems to suggest.

This "market" cap rate SHOULD be the one that is referred to in the formulas above, so I can rewrite them as follows:

• NOI / market Cap Rate = Property Value
• Property Value x market Cap Rate = NOI
• NOI / Property Value = market Cap Rate

Note: again in the above formulas, "market" cap rate is determined by the market, it's NOT calculated as the article implicitly suggests. Since cap rate is GIVEN, you can see the formulas above are no longer circular. I don't know how many "cap rate" articles, blogs that simply miss this concept to the point that I question the authors' understanding.

Cheers... Immanuel

Not sure if your specific question has been answered but IRR is usually stated annually. A $30k investment yielding 18% IRR will turn into $68,634 in 5 years as you have calculated. A good rule of thumb to use is the rule 72. This rule calculates how many years it takes for your investment to double at a given annual IRR. For example, an investment yielding 14% IRR will double in roughly 5 years (72/14 = 5.14). So it would make sense that your $30k investment will be more than double in 5 years since it's paying 18% Annual IRR.

Cheers... Immanuel

Well this is the issue I have with cap rate in this particular scenario. I instinctively think that Property B would be the one to sell or refi (as you apparently did also). There is actually a good reason for this and it's because property B is unlevered (i.e. all equity) so I know the yield is not efficient or optimized. But this goes against the notion that you mentioned in your earlier post that cap rate should be a good indicator to decide which one to sacrifice because it puts the properties on a level playing field without regard to equity. In this scenario, the cap rate analysis actually leads to a wrong decision precisely because it takes equity out of the equation. Although Property B has a higher cap rate, it is the right one to sacrifice because its yield is not as optimized as Proprety A (i.e. a leveraged 8CAP can easily yield 15%  while an unleveraged 10Cap would yield... well 10%). 

Cheers... Immanuel

Well that's an interesting scenario. I haven't had the fortune to be in that situation but how would you pick the sacrificial lamb? Suppose you have property A with 8%Cap and 25%Equity and property B with 10%Cap and 100%Equity (owned outright). Would you get rid of the property A because it has the lower cap rate?

Cheers... Immanuel

@Aaron K.

I can comment from my own situation since I'm going through this process. I have a rental that is now worth 2.5x with NOI staying the same since purchase (i.e. so cap rate based on purchase price has been the same which is 10%). This is very consistent with the scenario described by the OP. So my options are to SELL OUTRIGHT and redeploy or REFINANCE some cash out and deploy. How would I use cap rates to decide?

What I'm doing now is running Cash on Cash and IRR analysis on both scenarios (i.e. SELL OUTRIGHT vs. REFINANCE). And yes, this analysis requires me to assume exit at some point so I run different hold periods i.e. 10, 15, 20 years with assumed sale prices at disposition. This analysis helps me with:

• - Which option has higher yield/return
• - Whether or not I’m going to be cash flow positive
• - Comparison to other sector investments (i.e. stock/bond portfolio, mutual funds, etc.)

When it comes contrasting Cap Rate analysis vs. CoC/IRR analysis, I find:

• - The data you need to do cap rate analysis is already about 80% of the data you need to do a CoC/IRR analysis so might as well do the CoC/IRR.
• - After doing a cap rate analysis, I feel the need to do CoC/IRR anyway to verify the result of the cap rate analysis.
• - I still need to do CoC analysis to make sure I'm cash flow positive.

Now when you're getting into an investment initially and having to choose from a few similar properties I can see how you can use cap rate for comparison but when it comes to SFR's I'm not sure if cap rate is any better than the 1% rule (which is way simpler than cap rate).

Incidentally, I just noticed Grant Cardone just posted about how important CoC is to him and how CoC had kept him out of trouble throughout his career. :-)

Cheers... Immanuel

I'm in that situation. I could care less about cap rate (especially if it's an SFR, which is what I have). Right now I'm considering selling and redeploy OR cash out refi and deploy. I guess I could calculate and recalculate cap rate every month but what for? It's irrelevant, I'm more interested in my Cash on Cash and/or IRR.

Cheers... Immanuel

When it comes to the idea "that you can increase the value of the property to decrease the cap rate", I don't have a different explanation, I just think that statement doesn't make much sense. One of the main objectives of investing in a property is to increase value. So if you are already able to increase value then why do you care that cap rate decreases or increases? You've already achieved your objective. Besides, if you're talking about "market" cap rate you CAN'T increase or decrease it anyway because it's determined by the market.

Cheers... Immanuel