Hi, all I’ve been studying all the information i can find on REI, and i have to ask another newbie question. I’m having a hard time understanding how cap rates work and what they actually effect. Can anyone elaborate for me what they mean?? And do they only affect commercial / residential buildings?
here is a link to an article that i find helpful;
http://www.findarticles.com/p/articles/mi_qa3681/is_199608/ai_n8758107
Hope this helps.
Cap rates are deceptive. I’d only look at them to see what others might be buying and selling at, not as an indicator what I would buy or sell at myself.
Better metric is the cash-on-cash return. This will give you an idea of how soon you will get your money back if you put down any money out of pocket.
I agree with RKim regarding cash on cash return…
Cap rates give you a simple return rate based upon an unleveraged investment by taking the NOI and diving by the price.
Any measure (CAP too) can vary quite widely from property to property depending upon the asset class, tenants, location quality, building quality, availability of financing… etc…
It’s a good measure to look at from afar if the building is running at the calculations on the set up as to a generalized return.
Sorry for anyone who have seen this post before. But wanted this person to get this information instead of looking for my previous post. Again, sorry.
Cap Rate - Capitalization Rate
The Capitalization Rate or Cap Rate is a ratio used to estimate the
value of income producing properties. Put simply, the cap rate is the
net operating income divided by the sales price or value of a property
expressed as a percentage. Investors, lenders and appraisers use the
cap rate to estimate the purchase price for different types of income
producing properties. A market cap rate is determined by evaluating
the financial data of similar properties which have recently sold in a
specific market. It provides a more reliable estimate of value than a
market Gross Rent Multiplier since the cap rate calculation utilizes
more of a property's financial detail. The GRM calculation only
considers a property's selling price and gross rents. The Cap Rate
calculation incorporates a property's selling price, gross rents, non
rental income, vacancy amount and operating expenses thus providing
a more reliable estimate of value.
If we have a seller and an interested buyer for particular piece of
income property, the seller is trying to get the highest price for the
property or sell at the lowest cap rate possible. The buyer is trying to
purchase the property at the lowest price possible which translates into
a higher cap rate. The lower the selling price the higher the cap rate.
The higher the selling price, the lower the cap rate. In summary, from
an investor's or buyer's perspective, the higher the cap rate, the better.
Investors expect a larger return when investing in high risk income
properties. The Cap rate may vary in different areas of a city for many
reasons such as desirability of location, level of crime and general
condition of an area. You would expect lower capitalization rates in
newer or more desirable areas of a city and higher cap rates in less
desirable areas to compensate for the added risk. In a real estate
market where net operating incomes are increasing and cap rates are
declining over time for a given type of investment property such as
office buildings, values will be generally increasing. If net operating
incomes are decreasing and capitalization rates are increasing over
time in a given market place, property values will be declining.
If you would like to find out what the cap rate is for a particular type of
property in a given market place, check with an appraiser or lender in
that area. Be aware that the frequency of sales for commercial income
properties in a given market place may be low and reliable capitalization
rate data may not be available. If you are able to obtain a market cap
rate from an appraiser or lender for the type of property you are
evaluating, check to see if the cap rate value was determined with
recent sales of comparable properties or if it was constructed. When
adequate financial data is unavailable, appraisers may construct a cap
rate through analysis of its component parts thus reducing the credibility
of the results. Cap rates which are determined by evaluating the recent
actions of buyers and sellers in a particular market place will produce
the best market value estimate for a property.
If you are able to obtain a market cap rate, you can then use this
information to estimate what similar income properties should sell for.
This will help you to gauge whether or not the asking price for a
particular piece of property is over or under priced.
NOI NOI
Cap Rate = -------- Estimated Value = -------------
Value Cap Rate
Example 1: A property has a NOI of $155,000 and the asking price
is $1,200,000.
$155,000
Cap Rate = -------------- X 100 = 12.9 rounded
$1,200,000
Example 2: A property has a NOI of $120,000 and Cap Rates in the
area for this type of property average about 12%.
$120,000
Estimated Market Value = ------------ = $1,000,000
.12
Net operating income is determined by subtracting vacancy amount and
operating expenses from a property's gross income. Operating expenses
include the following items: advertising, insurance, maintenance, property
taxes, property management, repairs, supplies, utilities, etc. Operating
expenses do not include the following items; Improvements such as a new
roof, personal property such as a lawn mower, mortgage payments,
income and capital gains taxes, loan origination fees, etc.
Appraisers use the Income Approach, Cost Replacement and Market
Comparison methods to estimate the value of property. The Income
Approach utilizes the theory of Capitalization.