Can Someone Explain CAP Rates To Me Please?
I hear talk of CAP rates all the time and have never found a simple explanation of what they are and they are used in real estate investing. I would love one if anyone has one.
Thanks in advance,
It's the one-year cash flow divided by the value of the property in present-value terms. The value of the property is the sum of the net present values of the cash flows during the projected holding period and the value of the reversion.
The value of the reversion is what you expect to get when you sell.
And example might be an operating income of $824,286.
If the net present value of the cash flows over a 10-year hold is 5,426,825 and the net present value of the reversion is 3,823,371, then the cap rate is 8.91%.
Sophisticated investors get appraisal numbers they can trust, and make a go-no-go decision based on whether the deal gives them a cap rate as large as they're looking for.
thank you for the answer. I hate to ask again, but is there a a way you can explain it in a little more basic terms?
My rough understanding of CAP rates is that there are the rate of return one could expect from a property each year.....is this way off base or just to general of an understanding?
Flacrops that was the most complex explination i ever heard.
OK, it's a time value of money thing. Let's analogize to a bond. If you buy a bond that represents $1,000, that means that say, 10 years in the future you'll get $1,000 (which is worth much less today, say $573). If the bond pays 8%, that means you'll receive $80 in interest annually, or $800 total over the life of the bond. It's present value is much less ... for the sake or argument $600. If you add those two together, you'll get $1,173. That means that the bond should sell in the market at a $173 premium, all other things being equal.
Now, what would the "cap rate" be for this bond? It would be 80/(573+600), or 80/1,173, or 6.82%.
Real estate behaves like a bond, not a stock; meaning it is sensitive to interest rates.
The "Cap rate" is the "interest rate" (I use that in quotes because owners aren't lenders) that owners demand from their properties ... meaning the amount that is necessary to reach before they will make the investment. If the investment won't achieve that cap rate, they won't put the money in. If the investment exceeds that cap rate, the deal gets done.
The market value of apartments, and commercial income properties, is determined by their "cap rate."
Cap rate is net operating income (NOI) divided by the property value.
The cap rate can be used to determine what the expected return is, and if the investment will be profitable.
Example: A small apartment building produces $10,000 annual NOI and its seller is asking $100,000 for the property. That's a 10% "cap rate."
Single-family rental house valuations have nothing to do with "cap rates." Instead, they depend on recent sales prices of comparable nearby houses.
Quote:Example: A small apartment building produces $10,000 annual NOI and its seller is asking $100,000 for the property. That's a 10% "cap rate."
My ex-wife is a commercial real estate appraiser. I know what I'm talking about here. Your example here is dangerously oversimplified (hell, even my complicated one was oversimplified, because you have to use a yield rate and a terminal cap rate to get the respective net present values!).
If you want to just call what you did "cap rate" that's fine as long as everyone understands that isn't really and truly a cap rate as anyone actually doing the business of real estate investing on a professional level understands the term.
Maybe you could get away with calling it "quick cap rate" or "back of the envelope cap rate".
Quote:Single-family rental house valuations have nothing to do with "cap rates." Instead, they depend on recent sales prices of comparable nearby houses.No, homes (and any other real estate) can be evaluated by the income approach, or the replacement cost approach, or the market approach. Only the "income approach" has anything to do with cap rates, and that's how one is investing if one is renting them out.
Only the market approach is relevant to flippers and the like ... they're not holding for any length of time.
The replacement cost approach is the least usable of the three ... mainly relevant only to insurance concerns.
I'll explain it in several ways.
FYI: NOI is net operating income. = income after all expenses are paid (except for the debt service aka mortgage).
ROI - return on investment.
1. The ROI you would recieve if you were to pay cash for the property. In other words, you pay $100,000 for a property that generates $10,000 per year (NOI)
so ROI / NOI = CAP
2. It is the function (or relationship) between price paid and income that it will generate.
3. Here's an example. When you buy a car you don't care how big the gas tank is or how far it can go on one tank, you want to know how many miles to the gallon it gets.
Cap is smilar. In this example the gas tank size would be the price paid, the distance you can go on one tank would be the Net operating income and the miles per gallon would be the CAP.
In short, it allows you to compare investments that are not alike on an equal playing field to help you determine which is the strongest investment. If you have 2 investements that you are evaluating, all else being equal, you'll go with the one with the highest cap.
Keep in mind that cap does not take into consideration mortgage rates, ammoratization, size of down payment, etc.
Feel free to PM me if this doesn't clear it up for you
Well, flacorps, I'm sure that for MW1509 that was as clear as mud, but it seemed to cover the ground.
First, if you're dealing in the small income producing properties (1-4 units) a cap (capitalization) rate is of little if any value. So maybe you need to wait for the right time to get a more detailed explanation.
There are many different ways to extract a cap rate. I don't want to teach a course, but the capatilization process actually converts income into value. That's the real benefit of a cap rate. I'll explain that down below. You need to play with the formula below. There is an inverse relationship between the cap rate and the degree of risk. All things being equal, a cap rate of 15% is much riskier than a cap rate of 10%.
The easiest (also least accurate) way to calculate a cap rate is : Net operating income(NOI) divided by sales price(V).
NOI/V=Cap Rate(R)
$10,000/$100,000=0.10 (Usually expressed as a per centage {said to have a 10%. cap rate.)
Here's, the real benefit of getting the cap rate for COMPARABLE properties. With this information and knowing the (NOI) of the property you're interested in, you can calculate what the property is worth.
NOI/R =V
$10,000/0.10=$100,000
The thing that takes skill is knowing how to accurately get to NOI for the subjet. And how to recognize several variables to accurately extract the cap rate of the COMPARABLE properties.
[ Edited by sammyvegas on Date 10/27/2003 ]
I agree with sammyvegas. Capitalization Rate, or Cap Rate, is most often used to determine the value of a property for which there are no comparable sales numbers.
For example, a 24 unit apartment building does not get sold very often so you would be hard pressed to find comparable sales numbers for this property. You solve the problem of determining the value of the property by dividing the property's Net Operating Income by your desired capitalization rate. If you require a cap rate of 10% for a property with $130K in annual net operating income, then you would not want to pay more than $1.3MM for this property.
Assuming you own the property free and clear, Net Operating Income is what is left over from your annual rental income after all your bills are paid for the year.
Cash flow is your Net Operating Income minus your Debt Service (P&I only). Cash flow is not used in cap rate calculations.
Flacorps has confused Internal Rate of Return with Value. His explanation of Value is really closer to the calculation of IRR, though it is not really the IRR. IRR is not a factor in the calculation of the Cap rate.
As someone has already mentioned before, the cap rate is of little value for properties where comparable sales establish the FMV.[ Edited by DaveT on Date 10/27/2003 ]
thank you to all who took the time to help explain CAP rates to me. It has helped a great deal. My line of work is the fee management of apartment properties and I'm just now starting to look into buying a commercial property for myself on the side. I had a rough understanding of what CAP rates were, but this has helped clear up the concept for me.
Thanks again,
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