What Are CAP Rates?
I posted this same question in the Commercial area since I read alot of posts with this "CAP" word in there but I guess they don't know what it is either since I received no replies on it. I hope someone her can explain to me what they are.
What are they?
How are they determined?
What are good ones?
What is so important about them?
Thank you.
Sure. a CAP rate is used primarilly with income properties and is a prime determining factor in estimating it's value. As a buyer, the higher the CAP rate when you purchase, the better.
For example, assume I want to purchase an income property that has a net operating annual income of 60,000 per year. The purchase price is $600,000. The "CAP RATE" is 10%, or, $600,000 x 10% is $60,000. If the purchase price had been higher, the CAP rate would be lower accordingly. Generally, a 10% CAP rate is very good when purchasing income properties, and most I have seen, in my area at least, run approx 7%.
I hope this helps.
So is the Net Operating Annual Income (NOI) the gross rents minus maint minus insurance minus taxes? And where do I factor in the mortgage payment?
Thank you.
To calculate a Cap Rate (R) you would use this formula.
R1= Loan Rate % (100) x (1-Down Pmt %)
R2= Return % on investment expected x (Down Pmt %)
Cap Rate (R)= R1+R2
Value (MAO) or maximum offer = NOI divided by Cap Rate (R)
Example: NOI = 35,000 PER YEAR
Loan Rate is 7.5%
Down Pmt = 20%
Return on Investment = 20%
R1=(0.075 x 100) x (1-0.20) = 6
R2=(0.20 x 100) x (0.20) = 4
Cap Rate (R) = R1 + R2 = 10% or 0.10
Value = 35,000/0.10 or 350,000
What this tells you is based on the NOI and if you want to earn 20% back on your DOWN PAYMENT (your investment) you should not offer more than 350,000 for your purchase price.
[ Edited by JoDa on Date 09/23/2004 ][ Edited by JoDa on Date 09/23/2004 ]
... or this formula v =noi/rate = value or
rate = noi/value = rate.
Another way of looking at the NOI is that it is the profit you would make if you owned the property free and clear (no loans). The CAP rate is NOI divided by property price expressed as a percentage.
Actually, the higher the cap rate the greater your return should be. But, with ANYTHING, and this is commonly not talked about in this forum, the higher the cap rate, generally, the higher the risk. And it is a capitalization rate (cap rate for short). Net lease deals (sale-leaseback by good credit tenants for 15+ years) will go with low cap rates. I've got a listing sheet in front of me from Restaurant Capital, LP, they are asking a 6.5% cap rate on IHOP restaurants in texas, yesterday I was looking at a cap rate sheet from some other broker that was asking in the 5% range for Jack-in-the-box net leases...
But, then you get into mini-storage, hotels, motels, and the like, cap rates go into the double digits.
Thank you all very much for the information. It seems I have alot to learn about multi family unit purchases.
With all due respect to the prior posts the information provided was incorrect. Capitilization rates are simply the annual Net Operating Income (NOI) divided by the purchase price. For example, if a 20 unit apartment building has a gross income of $15,000 per month but it's expenses are $5,000 per month this provides a NOI of $10,000 per month or $120,000 per year.
If the purchase price were $1.2 million then the cap rate is 10% ($120k / $1200k).
All ordinary operating expenses are included for the NOI calculation but finance and capital (large repair) costs are not. Expenses include items like heat, electric, water, lawncare, gas, sewer and trash, snow removal, etc. However, a major roof repair would not be included as it is a capital cost.
Some good points were made about properties with higher CAP rates potentially having more risk but that should not be your sole determination of the potential purchase. For example, a property that has been seriously mismanaged may have a low CAP rate and still be a poor deal. That is, the seller may claim a proforma (as if it were fully occupied) NOI and ask a higher price when in fact the property is actually only 70% occupied and most tennants haven't paid their rent for the last 2 or three months. This is one example where not performing one's due diligence and accepting the advice to look for low CAP rates would likely cause you to lose the entire investment.
In general, higher CAP rates typically mean less cash flow risk, if the numbers are actual numbers, not estimates or "proforma", as you will have greater cash flow. As noted above such properties may (or may not) lag others in appreciation but this is a controlable factor. For example, if someone fortunate enough to purchase a building with a CAP rate of 14% (using actual verified income and expense figures) the building will pay for all expenses, the entire loan costs at 100% financing, and still kick off substantial free cash flow each month. An experienced investor can use this extra cash flow to remodel and improve the building to greatly improve it's value. At sale time this type of investor can often then remarket the property at a lower CAP rate, say 8%, which results in a higher sale price. This type of investing take more work and experience but can greatly outperform the strategy of buying properties with low CAP rates and "hoping" for appreciation. In addition it is ultimately safer as by definition properties with low CAP rates have lower free cash flow and are often the first properties to fail in any real estate, especially rental, downturns. This tends to be especially true if the investor does not have substantial resources to see them through any tough times.
One of the best books on the subject is: How to Buy & Sell Apartment Buildings, Vollucci, John Wiley & Sons, Copyright 2004, ISBN 0-471-65343-8, $34.95.
Study first, then seriously consider mid-sized properties as it tends to be easier to manage several larger properties than it is to manage many smaller ones. The cash flow and appreciation also tend to be just as good and often better.
Good luck.
REPrincess,
Do not rely on CAP rates or Gross Multipliers for anything other than advertising. I use it as an indicator of what cash flows may be in a given area. That is CAP rates are likely to be much higher in Oklahoma City than in the San Francisco Bay Area. This tells me that it is much easier to get cash flows to work in Oklahoma.
You should use a spread sheet for your calculations to evaluate whether a deal makes sense. An alternative is to use the PROFORMANATOR in the MYTOOL section of your MYTCI.
I don't agree that previous posts are incorrect (or at least my conceptual fictional examples). Cap Rates are nothing more than mathematical points of reference. If you want to determine a Value for an investment based on some sort of financing or TOTAL CASH DEAL, use what I have shown you (I can name the reference material if want it). If you want to determine a Cap Rate based on what the Seller wants (ASKING PRICE), then use NOI/Asking Price. If you want to find out what NOI is use (Cap Rate) X (Asking Price) which I believe is totally useless in my opinion. It's all mathematical and it doesn't guarantee anything, and use it anyway you want. It is an analytical mathematical tool used with your own situation and should not in anyway be used totally on its own merit.
Well, being a commercial real estate appraiser and working with cap rates on a daily basis, I think I know what I'm talking about. Its real simply.
A property is listed at $500,000 with $50,000 in NOI indicates a 10% cap rate. if you are able to negotiate a purchase price of $450,000 on the $50,000 of NOI, you've increased the Cap Rate to 11.1%.
Would anybody like to argue how a lower price on the same NOI would decrease your return? Ergo, the higher the cap rate, the greater the potential return. A cap rate can be used as a method of valuation and comparison.
RMDane,
Nicely stated.
I would add that CAP rates are the most reliable of all evaluation methods as you are using actual expenses (if you are performing due diligence by checking all seller supplied figures/information such as utilities, etc.) and actual income to arrive at the NOI and subsequently the CAP rate. No other commonly used method accounts for the actual expenses (software designed to evaluate properties by inputing expected expenses uses the same processes as calculating the CAP rate so you are in effect following the same process even if it's called something else).
Other common methods, such as gross rent multiplier, $ per square foot, price per unit, etc. do not include actual expenses. They are useful guides for comparison to other properties but they do not provide the information on actual expenses (and therefore cash flow/profit) that using the CAP rate method does.
Anyone who has evaluated multi-family in Texas and at least one other state will quickly realize some of the key issues. If one simply used the price per unit or gross rent multiplier, etc. in Texas to purchase properties you would likely find yourself paying out more than you made (negative cash flow), unless you put a substantial amount down, as the utilities, water in particular, costs in Texas tend to be several times what they are in most other states. I've seen properties with $35k per month gross rents having nearly $10k a month in water/sewer/trash expenses. A similar complex in Colorado typically runs maybe $3k to $5k a month for water/sewer. Using the CAP rate method it will be very evident that properties with inordinately high costs often will not generate a profit or can even produce a negative cash flow. Most other methods do not provide the same useful data and ratio's.
Please also note that to figure one's total Return On Investment (ROI) you must have accurate expenses and income as well as reasonable data on expected appreciation so generating the CAP rate is in fact the basis of nearly all subsequent evaluation techniques.
Learn it, understand it, and do it, you'll make fewer mistakes and see higher returns if you fully understand how to generate the NOI correctly, how to caluculate the CAP rate from the NOI and gross income, understand how this affects your cash flow before financing, how it affects it after financing, and finally how you can implement plans to raise your income, decrease your expenses, and improve your properties to increase your total return.
Happy investing all.
You can analyse the numbers from here to eternity, but I am working out of a 14 unit apartment builiding where the CAP rate was excellant, except the previous owner had other buildings and the labor for repairs was on the very low side since he could charge that to his other buildings and
(2) the plumbing is 30 years old. This is Los Angeles, and 30 year old plumbing should be "red flag" but again the CAP rate was excellant, and so the new owner has a plumbing problem thats killing him. I think he should have spent more time checking out the building, or talking to the tennants.
Cap rates never worked for me
[addsig]