Cap Rates
I've been in the multifamily industry for over 5 years now and, while I have an understanding of what is good or bad cap rate is, and I know the general formula, I'm having a hard time visualizing the appropriate set of numbers to varify to process in my head. Is NOI a per unit per month number or a yearly total divided by the price per unit?
Thanks
Hi, the CAP rate is the yearly net operating income (NOI) divided by the purchase/asking/offer price. For example: say you want to purchase a 10 unit apartment building that generates $6000 per month gross income; let's assume it takes $2500 per month to maintain and run the place (including ALL ordinary expenses and the vacancy allowance); the difference is $3500 per month times 12 months or $42,000 per year net operating income (NOI); Now, let's assume the seller wants $420,000 for the property; the CAP rate on the asking price is your yearly $42,000 NOI divided by the $420,000 asking price, or 10%. Let's say you have found a motivated seller, you are a good negotiator, and your offer of $350,000 is accepted; your CAP rate is $42,000 NOI divided by the $350,000 offer/purchase price, or 12%.
, lawncare, owner paid utilities, insurance, taxes, managment fee's, etc. must all be included in the expenses). Then your yearly income would be $37,000 and your CAP rate given a $350,000 offer/purchase price would be only 10.6%. This is still pretty good but it is quite a bit lower than the $42,000 you expected to earn and the resulting 12% CAP rate.
What is a good CAP rate? Everyone has their different standards, if you have money to put down or can negotiate very favorable terms for seller carryback, deals with CAP rates in the 7% to 8% range may make sense (in a growing area/rental market) but in general I don't even look at deals with CAP rates lower than 10% and I prefer 12%. Yes, it's harder to find such deals (more work is needed) but buying basically good property with higher CAP rates leaves me more room for error and more room for future appreciation (when I sell I try to sell at 7% to 8% CAP rates, which means a higher selling price). Having said that, most properties with a 12% or better CAP rate are going to have problems that you will have to solve to increase the value, or even to keep operating. If you run the math for financing costs you will find that properties with a 12% cap rate or higher will fully pay for themselves at 100% financing (at today's 25 to 30 year fixed interest rates). Always a plus in my book.
Beware of "stated" CAP rates, most realtors/sellers improperly calculate the CAP rate, ussually by leaving out many of the operating costs, which gives the impresion of a higher (more favorable) CAP rate than is true. For example, let's say the same property described above had $5000/year of snow removal costs that were "accidently" left out of the expenses (just an example, maybe true in Alaska
I prefer CAP rate for evaluation but price per unit and price per square foot can also be useful measures. CAP rate tends to give the most complete picture however, so it is a good idea to develop your own spreadsheet with all normal expenses and areas to put in your income and financing costs to speed up the process and to help ensure you don't overlook major expenses.
Lastly, let's say you you are now selling the 10 unit building 2 years later. Let's say that your NOI has risen to $4500 per month, or $54,000 per year due to your great managment skills. Let's further say that the economy is still fairly good, interest rates are about 7% and there is still a strong market for apartment buildings (look at current offerings and recent sales); what should you charge for your building? Let's say that after a bit of research you find that several apartment buildings have sold in the same area with CAP rates of 8%, take your NOI of $54,000. Here's how you calculate your asking price; $54,000 NOI / .08 (8% CAP rate) equals an asking price of $675,000. You may add a bit if you don't need to sell it quickly, or subtract a little (or offer to take back a second mortgage, etc.) for a quick sale but that's how you can use the CAP rate to determine an approximate asking price when selling.
Interest rates do not effect the CAP rate but do effect the price of the property, and as a result, what is a "reasonable" cap rate in the current environment. If interest rates were at 10% you might have trouble selling at the 8% CAP rate becuase a buyer would need to put more down to to keep the investment profitable (finance only $350,000 for example).
To conclude, interest rates have no bearing on the actual CAP rate but investments with lower CAP rates are more sensative to interest/financing costs as higher financing costs can turn an otherwise good investment into a losing one. This is one of the problems with ARM's on investment property. A property with an 8% CAP rate may look great with a 4.00% ARM tied to the MTA index but may cost you money (negative cash flow) if the MTA index rises to 7% or so. Many people only look at the financing package now, they forget that they may need to refinance in 3, 5, or 7 years. What will the income of the property be then and what will the interest rates be? It's always better to start with a higher CAP rate whenever possible as the answers to the future income and interest rate questions are unknowable.
Hope that helps.
Mantis, tremendous help, clear as day. I appreciate your time and feel that dumb as a box of rocks feeling clearing from my head. Thanks again,
Great post Mantis and the point about watching out for stated cap rates is a biggie. Especially watch the estimations on insurance and taxes as both of those will go up with a higher purchase price.
Ray Higdon
when figuring out the cap rate is the monthly mortgaged figured in there?
No, Cap rate is figured on NOI before debt
For long term hold in general, is it better to get a fixed rate loan eventhough the interest is higher, and CAP rate is also low, and lower cashflow? Therefore, your future CAP rate will not be affected from interest rate.
From what I know the logic of CAP rate not including debt service is CAP rate allows you to view the return without the effect of leverage.
Some folks prefer higher leverage and others prefer lower leverage. People who are mostly interested in cash flow to provide an income might consider no debt on the property. With a CAP rate you can still compare two properties even if the debt levels are completely different.
There are other measures and other indicators of value.
John
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