Steve,
When looking at ANY property, I look for the same two things: Equity AND Cash Flow. Cash flow is the lifeblood of every business - without it you ARE going out of business. Equity is your insurance that you can get out if need be.
Mike
the thing with cash flow is - do you have the resources to increase cash flow in a property - especially commercial property.
additionally, you can also increase “equity” in a property by increasing its value - again, thing to look at is do you have the resources (or can you get the resources) to accomplish this?
Never go by cap rate!!! It is absolutely meaningless for your business. Do a proper cash flow analysis using real world numbers. Businesses fail because they don’t have the proper cash flow, not because the cap rate wasn’t right.
Mike,
Why wouldn’t you use cap rate as a qualifying factor? I realize that you have to get the real numbers in order to get an accurate cap rate, and that the advertised cap rate is a bunch of BS, but I look at cap rates (once I have established the real numbers ) to know where I want to make and offer. I work backwards from the real expense numbers and rents to find an offer that fits my cap rate or return criteria.
DB
Using market cap rates that don’t have anything to do with debt service are meaningless to an individuals business. Using your own cap rate based on your own business makes life easier.
Loan at 70% of properties value
Equity at 30% of properties value
.70 X .088 (ex. mortgage constant) = .0616
.30 X .10 (desired cash on cash return) =.03
.0616 + .03 = .0916 or 9.16% cap rate
If you typically get the same rate and terms of your loan to finance 70% of the property, the mortgage constant will be the same or very close no matter the loan amount. If you have the same cash on cash return requirements for each property you buy (equity capitalization rate), your overall cap rate will be the same. If one property cash flows using your overall cap rate for your business, all properties you buy with the using the same rate and terms of financing and at the same LTV, all properties you buy at that cap rate will cash flow.
The magic of math!
DB,
You certainly can use cap rate as a qualifier or screen (I don’t personally). The point is that you should not base your purchase decision on a cap rate.
What does cap rate really tell you? I would argue that it tells you almost nothing useful. If you are trying to determine value using cap rate, where do you get cap rate? From the seller? From a realtor? Or is this your DESIRED cash on cash return? Cap rate only really tells you something about the property if you are paying cash. Most people are not paying cash and therefore cap rate tells you absolutely nothing about profit. Is the property profitable? Is the property cash flow positive WITH THE DEBT?
As I said before, in my opinion, deciding on the purchase of a property is really as simple as cash flow and equity.
Here’s what I do. I have looked at a bunch of properties in my area. I KNOW the retail value from experience. I must buy properties at a minimum 30% discount (less repairs). Then, if we’re talking about an apartment building, I determine the gross rents by looking at the written leases, (and then later confirm that by talking to the tenants when I inspect the property). I know that operating expenses are 45% to 50% of gross rents. From this, I can determine NOI on my own (not relying on anything from the seller except the leases). I can quickly determine the debt (mortgage payment) with a mortgage calculator. I base the loan amount on 70% of the value (that I KNOW from experience). From this info I can determine cash flow.
I know that my maximum purchase price must be the lower of 70% of the market value and a purchase price that will give me a cash flow of $100 per unit per month (minimum) using the 50% expense rule.
Following this formula almost guarantees that you will make money.
For commercial buildings other than apartment buildings, you can still find income from the leases and determine expenses by looking at the lease (who is responsible for which expenses). If it’s a triple net lease, I would still include a minimum expense figure of 20% of gross rents for all the misc expenses (accounting, tax prep, possible lawsuits, legal fees, vacancy reserve, etc, etc, etc). The downside of some non-residential commerical buildings is that they can stay vacant for an ETERNITY!
Good Luck,
Mike
Good post Danny,
I agree.
Mike
Thanks for the response guys, I agree that the cap rate in and of itself is meaningless, but once you have your own system and criteria, you can start to realize what cap rate you need to fit your system. A side note, I am involved in a large (300 unit) apartment comlex, and the majority owners ( from whom we are learning a lot ) showed me an offer that they received on the complex. It simply stated that the potential buyers would buy the apartments at X.XX% cap rate. They had an established cap rate that worked inside their business, like Danny showed with his math. The actual price would be decided as they did the due diligence and got the accurate expenses and incomes. What do you think of an offer made this way? I see where it leaves a lot of negotiating room on both sides. Is this a normal way to do business and make offers at the “big boy” level?
DB
I agree with most of the post here.
You really need to do your homework.
know what you can handle and what you can not.
those two posts from dan and prop were so good, i copied and pasted them for my personal review. thanks 
but ofcourse now i have questions.
cap rate allows an investor to determine the value of a commercial property.
am i not right? i mean determining the cap rate is one thing - that’s where all the BS is involved and that only compounds the BS factor.
but if a solid cap rate is determined - then this is a BIG factor for determining value.
the problem with cap rate (in my humble opinion) is many “investors” and “commercial realtors” do NOT understand it.
i barely understand it! lol
but if it is used properly for a specific purpose (i.e. a necessary step in property evaluation) - then it is absolutely a great tool.
it’s like any other investment evaluation tool for any type of investment, be it rei or stock - once you know HOW TO USE IT, it becomes VERY valuable.
i like the word - “dynamic” to describe how an investor should go about evaluating investment prospects.
thanks for the informative posts!
A good way to think about the cap rate is just a multiple to get you from your NOI to the value (it’s a percent so you have to divide).
For every true investment, there is a return ON your investment (profit) and a return OF your initial investment (recapture). My example outlined the “band of investments” method to building a cap rate. Another quick and dirty way to get a cap rate is to combined your desired return ON investment and return OF investment. If you want a 10% return on your money and it will take you 4% of the NOI to return your initial investment for a predetermined length of ownership, you have a cap rate of 14%. Therefore if you only look at properties with a cap rate of 14% or more, you’ll save some time in evaluating.
To figure out a recapture rate for your return OF investment, here’s a simple equation that’s commonly used. It’s called the “straight-line method”
100% / Years of intended ownership = Annual Recapture Rate
If you plan on owning the property for 20 years it would be 100% or 1.0 / 20 years = 5% recapture rate.
EDIT: I should also add that the straight-line method assumes you will own the property until it becomes totally depreciated (falls into the ground) thus won’t have a resale. I said it was simple, not perfect!
That same equation is used when you figure out a reserve for replacement for the major component of a building. Instead of years of intended ownership it would be remaining economic life.
There are many more ways to build a cap rate, but those are the easy ways. I recommend that anyone looking for rental properties, figure out THEIR cap rate. This will be based on whatever discounts you require or a downpayment when purchasing, whatever financing your eligible for, and a desired return on your investment. It’ll tell you immediately if you should even look further into a potential deal.
Most investors and commercial agents stick to evaluating a deal based on market value and market cap rates. This will be good to know when you resell but has no bearing on YOUR purchase because you’ll only be willing to pay what it’s worth to YOU.