Walking and Talking … Cap Rates!
Cap Rates. You hear about them all the time, from people who specialize in investment real estate. They’ll says things like, “That property sold for a 6 cap,” or, “We’re looking for properties priced in the 9 to 10 cap range.” Today’s Walking and Talking podcast is all about Cap Rates!Photo Courtesy of @istockphoto.com
Today, you will learn 5 things:
- What is a cap rate?
- The reason why so many people are often confused about cap rates.
- The best way to remember how to easily calculate a cap rate for any investment property.
- The five main factors that influence cap rates.
- Why you should beware that all cap rates are not created equal!
Hit Continue Reading and listen to the Audio:
What is a Cap Rate?
Simply put, a Cap Rate (or capitalization rate) equals the Net Operating Income of a property, divided by Purchase Price:
Cap Rate = Net Operating Income ÷ Purchase Price
Net Operating Income for an apartment property is basically all of the income that is collected from the property, such as:
- Rental Income
- Late fees
- Pet fees
- Application fees
- Water income
Less any expenses that you would incur on the property, such as:
- Replacement of appliances, HVAC, etc.
What remains is your Net Operating Income (NOI).
When you are discussing cap rates, it might be in connection with the purchase price you paid for the property, the price you are considering paying for the property, or a price a seller is asking for the property (for instance a lot of times you will hear, “They are asking for an 8 cap for that property.”). In each instance you are refering to the price of the property in relation to the NOI it generates.
NOI/Purchase Price equals your Cap Rate
Examples at an NOI of $10,000:
If a property is generating $10,000 per year, and you wish to sell that property for $100,000. You are seeking a 10 cap. That’s easy enough to calculate in your head, right? $10,000 (NOI)/$100,000 (Purchase Price) = 10 Cap.
If , however, you are only to able to sell the property for $90,000, then it could be said that you can sell your property at an 11.1 cap rate. This time, the $10,000 NOI would be divided by the lower price of $90,000. $10,000 (NOI)/$90,000 (Purchase Price) = 11.1 Cap.
Now, let’s imagine that a bidding war breaks out on your property and you sell the real estate above your asking price. Let’s say $111,000. If this happens, then the appraiser would rightly say that the property transferred at a 9 cap. $10,000 (NOI)/$111,000 (Purchase Price) = 9 Cap
As you can see from these examples, the higher the price, the lower the cap rate. The NOI is a fixed number at $10,000, because that is simply the NOI that is being generated from the property every year. Only the purchase price changes.
Therefore, if a buyer is willing to accept the lower cap rate of 9, it simply means that they are willing to pay a higher dollar amount to receive the $10,000 NOI that is coming in each year. Conversely, if the buyer demands an 11.1 cap rate, based upon the property’s annual NOI of $10,000, then they will pay less for it; In this example $21,000 less.
Why so many people are often confused about cap rates
This is what throws a lot of people off. They forget that Annual Debt Service is not an expense. Therefore, annual debt service (ADS) has nothing to do with calculating a cap rate! Cap Rates don’t care if you borrow money against the property or not. Cap rates don’t care if you have an interest rate of 6% or 8% or 10%. Cap rates only care about the relationship between NOI and purchase price.
Accountants might say that I am looking at this wrong, but his is how I view this topic. If you take $100,000 down the street to your local bank and they pay you an interest rate of 1% – To me, you just invested your money at a 1 cap. If you take that same $100,000 and buy a couple of apartments that are netting you $5,000 each year in cash flow, then you have invested your money at a 5 cap.
The best way to always remember what is a cap rate
Assume you are always paying all cash for the property!
Now of course, you rarely will – but to determine the cap rate, ask yourself, “If I paid all cash for this property, what would be my annual return?” If you buy a property all cash for $100,000 and the NOI is $7,500 per year; you just bought that property at a 7.5 cap rate!
Conversely, if a property is generating $12,000 each year, and you are willing to pay a price that gives you a 6 cap, then be ready to pay $200,000 for that property ($12,000 NOI/$200,000 (Purchase Price) = 6 Cap.
As you can see in the last example, the cash on cash return percent will also be 6. That’s because, when you pay all cash for real estate, your cap rate is the same as your cash on cash return. Simply put, the cap rate is what your rate of return from cash flow would be if you didn’t borrow any money to purchase it.
5 major factors that impact cap rates
1. Interest rates:
The lower the interest rate a person can use to leverage his or her purchase, the lower the cap rate that person will typically pay for the property. That is because they are looking for positive leverage. For instance, for a great investment property, many investors like to borrow their funds at a lower rate than the cap rate they are buying at. If they buy a property at an 8 Cap, they want to finance the property at a 6-6.5% interest rate.
This results in a positive cash on cash return. The larger that spread becomes between the cap rate price they are paying, and the interest rate of the funds they are using to make their purchase, the more positive cash flow they make.
If interest rates increase to a number higher than the cap rates being paid in the marketplace, then negative cash flow is created, and few people want to buy real estate at a negative cash flow.
2. Quality of the property:
Buyers are willing to pay lower cap rates for a property if they believe that it will appreciate in value, continue to stay rented, garner increases in rental rates, physically stand up over a long period of time, and be relatively easy to manage.
3. Supply and Demand:
Not all investors purchase strictly for economic reasons. For the owner-occupied retailor, doctor, or office tenant, who believes they must be in a certain area for their business to prosper, the value of the building might become secondary – at which point limited supply in a particular area might drive down cap rates.
4. Like Kind Exchange Activity:
When there is a great deal of selling activity in a particular market, the desire to defer capital gains taxes, often result in a flurry of buying activity that drives down the cap rate.
5. Alternative Investments:
When competing investment rates, either from banks, the stock market, or pension funds, goes down, investors more easily rationalize accepting a lower cap rate when buying investment real estate.
Remember, not all cap rates are created equal!
Be careful when negotiating a deal where everyone is throwing around the term ‘cap rate’. When someone says to me for instance, “All I am asking for, for my property is an 8 cap? That’s fair, don’t you think?” My first thought is to find out how that person arrived at their NOI number?
- Have they inflated income to reflect street rents, or are they using actual rents that they collected over the last 12 months?
- Did they include a property management fee in their expenses ? A very popular comment you will hear is,”Oh, we just manage it ourselves, so we didn’t put in a management fee expense.” But what if I decide to hire a management company to run these apartments for me. I will have that expense!
- If I am buying the apartments in partnership with other people, I might simply want to be compensated for my managerial efforts.
The point here is that there are dozens of ways to arrive at an NOI figure. Their way of calculating NOI is oftentimes different than yours or mine. And, even if do they calculate it the same way we do, there are expenses that we will have as the new owners, that they don’t have. For instance, after the sale our tax rate will be based upon the new transfer price, which might be quite a bit higher than the assessed value currently being used to determine the property taxes.
The Cap Rate, and other ratios used to determine market value of property, can be found in my 6 page laminated flyer titled, Understanding the Fundamentals of Multifamily Property which will soon be made available at my site, www.GarrettScanlon.com
Question: Do you consider Cap Rates when purchasing real estate?