Cap rates and why they are important

General Real Estate Investing
1

I’ve noticed numerous people comment that cap rates are unimportant.

I’d like to take this opportunity to examine cap rates and explain why it’s crucial to understand them.

We can all agree that a cap rate will give you the Net Operating Income if you know the price.

Example 1,000,000 list price @ 8% cap rate = 80,000 NOI
(80k/1M) = 8%

You put down 20% (200k). 800,000 loan @ 6.5% IO(for simplified numbers) = 52,000/yr debt service.

Cashflow= 28,000
Cash on Cash return = 14%

It’s essential to know the meaning of cap rate and how to apply it to your cashflow analysis. This is basic stuff. REI 101.

It’s just as important to understand cap rates in the markets you are buying and selling in. It has very significant value. Let’s say B class assets in a given submarket typically trade at an 8% cap rate and have been for the past couple of years. It’s in a generally decent area but there hasn’t been an upswing for sometime. You notice that money starts coming into the area for commercial development projects(office bldgs, shopping centers etc). This will generally create an upswing in any market due to high job growth. Rental rates and occupancy increases, turn over decreases which increases your NOI to let’s say 100k. Now this area becomes more desireable and B class apartment bldgs are trading at 7 caps two years later.

See what this does to your value?

Before:
80,000 NOI / .08 = $1,000,000 value

After:
100,000 NOI/ .07 = $1,428,571 value

You sell the bldg at the end of year 3 for it’s value. Do you see what this does to your COCR?

Initial investment 200k. total CF for years 1 and 2 = 56000 and year 3 CF is 48,000 = total of $104,000

Total capital gains = $428,571 on the sale

total return = $532,571

Cash on Cash return for 3 years = 266% !!!

COCR for 1 year = 88.6%

That is huge.

Please check my math but you get the idea and the reasons you should be well aware of cap rates.

2

So cash on cash is the return for your Actual cash investment and Cap rates are an indecation of economic conditions?

3

Yeah you can say that, when markets are in an upswing typically bldgs trade at lower cap rates. The area becomes more desireable. It becomes a sellers market. If you know what to look for, you can use cap rates as a tool to calculate not only your projected cashflow during the holding period, but the value and overall return at the end of your holding period.

4

What does cap rate do for cash flow?

5

I’m not sure I fully understand your question?

Obviously, the higher the cap rate, the higher the NOI, the higher the cashflow.

Alot of people make the mistake of looking for the highest cap rate as possible but they overlook the reasons why it’s selling at such a high cap rate in the first place. If buildings in your submarket are trading at a 7 cap and you find a property listed at a 10 cap - Red flags should be going off in your head. There are reasons why, and you must be fully prepared to deal with them if you choose to purchase it.

I also notice some people say things like "if it doesn’t have atleast an 8 cap then I won’t even look at it. " That’s also a mistake. They completely disregard all bldgs listed between a 5-7.99% cap. There are also reason why buildings are listed high with a low cap rate in which you can capitalize on. The owners numbers are not the be all end all. It could be that the property is just severely mismanged but in a good upswing area, so the owner is trying to list it as high as possible.

Understanding cap rates is an important part of the game.

6

Commercial appraisals are usually always done by two methods; 1). Comparative Sales 2). Income approach

Cap Rates are used almost entirely for the income approach method and are even more prevalent on refinances. If your not taking into account Cap Rates you either not buying at a big enough discount or plan to negative cash flow.

7

Light,

Great example. Cap rate is a great tool for measuring commercial deals.

Similarly, if you are comparing investments and know the NOI’s and purchase prices of the buildings, as well as the local cap rate for your property type, you can measure whether or not you’re overpaying for an investment.

Cap= NOI/Price or Cap = NOI/value

Value = NOI/Cap or Value = 80,000/.08 = $1,000,000.

If an investor was looking at the property in your example and they knew local cap rates were 8%, they should not pay more than $1,000,000 for the property with NOI of 80k.

If the going cap rates were 8.5%, they wouldn’t pay more than $941k for the property.

Don’t forget depreciation and possibly higher returns!

8

Thanks Craig,

That’s exactly right. Cap rates are more important then just some ratio. Be well aware of them when you analyze the property/market.

Jordan

9

Lightbeing,

While I agree that your math is correct, I totally disagree with you that cap rate is important or even relevant. In my opinion, it’s all smoke and mirrors.

Here are my problems with cap rate.

  1. The market cap rate is determined by lookiing at data from comparable buildings that have sold in the same or similar market. In other words, it’s just comps.

  2. Where is this financial data (operating expenses, gross rents) coming from for these similar buildings that have sold? From the sellers? We all know and have experienced that owners overestimate rents and underestimate expenses. Garbage in, garbage out!

  3. According to the US Census Bureau, the vast majority of rental units in the United States are owned by small investors (I believe the number is 76%, but don’t hold me to that). We all know that the vast majority of new landlords fail in a short period of time. They fail because the pay too much and don’t have the cash flow. In fact, they don’t even understand cash flow or operating expenses. How is anyone supposed to get financial data from people who don’t even understand the topic.

  4. Even if the numbers were correct (they aren’t), the market cap would only tell you what the losers are paying for their properties. Therefore, if the market cap rate for your area is 8% and you buy a property at 8%, you are destined to fail also.

So, instead of using cap rate, I simply consider cash flow and equity at closing. Cash flow is the lifeblood of every business. Without cash flow, you will fail. Equity is your insurance that you can sell if things go wrong or the market declines. Cash flow and Equity are the basics of this business. If you have them, you will succeed. If you don’t, you will fail. It’s just that simple. Cap rate does nothing for you except give you an idea of the market value of a property, BASED ON FAULTY NUMBERS.

Mike

10

Mike,

I get what you are saying and I agree to an extent. Let me just clarify that I do not analyze a property based off of the owner provided P&L’s. I draw up my own proforma and verify from there.

While I can agree that there are alot of “losers” out that would cause inaccurate information, I don’t think this would cause such a reverse affect in major metropolitan areas. I could agree that the number of private investors is at 76% but I’m sure the majority of those are residential units(4 or less) and smaller D class assets. Major metro areas don’t have a tendency to cater to the unexperienced. In my area, most complexes are owned by experienced private investors, institutional investors, REIT’s, TIC’s, Hedge funds etc. It’s easier to find 100+ units then it is to find under 100 units. Metro area apartment bldgs are not only out of most of the inexperienced league but sellers, brokerage firms, lenders alike do not care to deal with them. So generally speaking, I think market cap rates are closer to accurate when you are referring to apartment complexes, specially a B class asset as I described in my example.

Now, I’m not suggesting that you calculate your cashflow based off of the cap rate however market cap rates and trends will help identify future value and projection. Normally, I will do a 5 year projection. If there is an influx of money moving into a given area, and high targeted job growth, it’s stands to reason that buildings will trade at a lower cap rate. The area becomes more desireable. I think it’s important to include this in your projections to show your possible future value and your IRR.

Cashflow and Equity are obviously important, it almost goes without saying. Cap rates help identify submarket trends and can project your future cashflow and equity(value).

11

Lightbeing,

Agreed. My primary concern with Cap Rate is that there are no accurate numbers for smaller buildings (less than 50 units), which is what most people on this forum are doing (including me). I certainly agree with you that the information should be a lot better for larger projects that are owned and managed by more sophistocated investors. I also agree with you that investors should know their local market and the underlying trends.

Happy Investing.

Mike

12

Ultimately, cap rates may not factor into your own analyses or be a go/no-go decision maker, but as an investor of income producing property you must understand the relationship that cap rates represent.

Here’s an example of a deal we put together recently. We put together a package for an investment group trying to obtain financing on construction of a multifamily building in NYC. We estimated costs, rents, expenses, etc. and based on our research we estimated a hold period of five years with a terminal cap rate of 7%. That number helped us derive a sales price we’d expect to receive in the fifth year of the investment, which helped us calculated expected returns. (your key ratio)

We had several offers from banks with differnt terms. One of the banks would only consider lending using a 7.5% terminal cap rate. That was their comfort level, which, holding expenses equal to our initial numbers, reduces our expected sales value and therefore the amount of money the bank would lend on this property. We used that as a comparison to other offers we received and went with the one that was most advantageous to our client.

I wouldn’t suggest anyone hang their hat on any one ratio, but it’s foolish not to understand how these numbers can affect your overall investment.

Craig

13

Now, suppose I am an investor who purchased your property after the cap rate becomes 7%.

Purchase price: 1,428,571. Down payment (20%): 285,714. Loan amount: 1,142,857. @6.5% mortgage rate, my monthly payment is 7,224 or 86,684/year.

My net cash flow after debt service is 100,000 - 86,684 = 13,316. Cash on cash 13,316/285,714 = 4.7%.

Wow!! Don’t you think I 'd better put it in my saving account?

CONCLUSION: Correct me if I am wrong, @7% cap rate does not give me a return, therefore no matter other buidlings selling at 3-4% cap rate, my 7% cap rate is not good! I am still paying too much?

E’

14

Sure, if you’re plan is to hold for only one year and then sell, your money is probably better suited somewhere else on an investment with those sample terms.

In my humble opinion, multi-unit buildings offer some great ways to create more value in the mid-long term hold, such as rental increases and lower expenses with more efficient management. Both things help increase value without having to spend a dime on repairs or capital expenditures.

Again, if you factor in a longer hold, say three to five years, you’ll enjoy depreciation and other tax benefits and probably a higher return even when discounted to today’s value.

15

That’s exactly right Criag!

There are a multiple ways for added value.

rkresnadi,

Since the submarket is strong a poised for additional growth it is still an attractive investment to many investors.

16

If that’s the case NOI isn’t so much important since no matter what the NOI is, there’s a way to create value, whether it’s a long term or short term.

After analyzing this thread, I would conclude NOI works the same as PV (Present value). It is used for comparison study, but cannot be used as an indicator that a property is a good deal or not.

17

No, do not think like that. NOI is very important. You always want to build off the current NOI.

What I am saying is that there are many investors that would be attracted to a 7 cap in a strong growing market. Institutional Investors buy 7 caps all day long. A stabilized asset in a growing market will trade easily. The investor will hold for cashflow, while he’s sees everything go up, including his appreciation. The investor could always add value to his asset as well.

18

Sorry, what I meant was Cap rate isn’t important to see if it is a good deal or not, but can be used for comparative study, like PV (present value).

Yes, NOI is important. You can see how much return, therefore, will tell you how good a deal is.

19

Good point although I think it would be better illustrated when you show the opposite effect. When people are buying at a 6% cap and barely cash flowing, try moving cap rates out to 8% or so and you will notice that you are in a world of hurt.

20

If you’re working a day job and making a set salary you can’t just walk into your bosses office and set your salary for next year because you want to make an additional $50k.

The good thing about REI is you can name your profits. If you want to make 100k or a 15% return on the next property work it into your analysis and back track to your offer, or set your selling price accordingly.