CAP Rate Real Estate – What is it and How to Use It

CAP RateINTRODUCTION

CAP Rate (Capitalization Rate) Analysis is the standard barer for estimating value of any large commercial  income-producing asset, including multi-family residential which is 5 units or larger, multi-unit commercial, strip mall, retail mall, office, storage, industrial, etc.  While the CAP Rate Analysis is not typically utilized by the bank appraisers for small multiplex, as investors we certainly can and should rely on it for even the smallest of our multiplex acquisitions, such as duplexes.

CAP Rate Analysis aims to estimate a value of an asset based on its’ income.  This is very logical indeed since the primary reason investors buy income-producing assets is for the income; appreciation is a desirable side effect to us, but it’s just that – a side effect.  What we are really after is the income.  Therefore, it is quit logical that the more income an asset can produce, the more valuable it is.

The foundational metric of income which serves as the basis for that CAP Rate Analysis is the NOI – Net Operating Income.  Let us define the NOI:

NOI

Simply understood, the Net Operating Income in an income-producing real estate asset is what’s left of the Gross Income after all of the operating Costs.  The operating costs might include such costs of ownership as property taxes, insurance, maintenance, vacancy, grounds-keeping, utilities, CAP EX (capital expenditures), and more.  However, it is important to understand that the Operating Costs, and therefore the NOI, do not account for the Debt Service (mortgage payments) – I discussed the reason for this here.

Thus, the formula for NOI is:

NOI = Gross Income – Operating Costs

(Where Operating Costs are the sum of all expenses excluding the debt service)

WHAT IS CAP RATE?

Capitalization rate is simply understood as a rate of return that an average participant in the marketplace will accept on his investment.  The thinking is simple enough: if an investor decides that she will deploy capital so long as the investment opportunity can generate at least a 10% return on investment, then she should reasonably be willing to pay $100,000 for an asset which generates $10,000 annually ($10,000 is 10% of $100,000).

In this case, the 10% is the CAP Rate, and the $10,000 return is the NOI.

Thus, the formula for CAP rate is:

CAP Rate = NOI / Value (Purchase Price)

While most investors think of CAP Rate as an asset-specific metric, I think it is important that you understand CAP Rate as a metric which measures the over-all investment conditions in a specific marketplace.  In other words, understanding that some investors will do better than others, nonetheless what are investor expectations and behaviors in the marketplace relative to a specific asset class…?

Establishing the CAP Rate in a specific marketplace can be a difficult proposition indeed.  In order to first-handedly research the CAPs it is necessary,  as the above formula dictates, to juxtapose the Sold Comps (Value) to the NOI of those sold comps. The problem with this, naturally, is that in order to establish the NOI we mast have access to both the Gross Income as well as the Operating Costs of the comp at the time of sale.  This is difficult indeed – what sellers disclose and what the MLS lists is not always completely accurate…

So, in order to gain a meaningful understanding of the marketplace it is necessary to do very extensive first-hand research.  Fortunately, if you make friends with a good appraiser and a good commercial lender, whose job it is to know the answers to these kinds of questions and as such they continually conduct exhaustive analysis of the market-place, you can usually rely on what they tell you.  Besides, don’t hesitate to ask other investors – they’ll tell you.  So, just ask…

CAP RATE ANALYSIS OF VALUE

<>So – in order to place value on a piece of income-producing real estate, you must establish 2 metrics: the going CAP Rate and the NOI of the asset.  Once you have gained knowledge of those two pieces of information, you can then simply invert the formula and plug the number in to arrive at a valuation:

CAP Rate = NOI / Value (Purchase Price)

Therefore:

Value (Purchase Price) = NOI / CAP Rate

FOR EXAMPLE

Let’s consider a 4-plex generating Gross Income of $2,000 per month.  If the Operating Costs are $900 per month, then the annual NOI is $13,200:

NOI = Gross Income – Operating Costs

Annual NOI = $2,000 – $900 = $1,100/month x 12 = $13,200

Now – let’s say that you’ve spoken to the right people and have established that the going CAP Rate for a building of like-character in this location is 10%.  Now that you know the NOI, and the CAP Rate, you can input the numbers into the formula to determine Value (how much you should pay):

Value (Purchase Price) = NOI / CAP Rate

Value (Purchase Price) = $13,200 / 10% = $132,000

Thus, if you are willing to deploy capital so long as you receive a 10% return on your money relative to the Capitalization Rate, then you would consider paying $132,200 for this building.  However, let’s say you determine that you are unwilling to deploy capital for anything less than a 12 CAP.  You don’t want to be satisfied with an average return in the marketplace; you want to beat it!

In this case, you would not be able to pay any more than $110,000 for this asset:

Value (Purchase Price) = $13,200 / 12% = $110,000

CONCLUSION

Such are the key concepts and rationale involved in approximating value of income-producing multi-unit property based on a CAP Rate Analysis.  I need to alert you to the reality that CAP rates vary dramatically throughout the country.  For instance, in Lima, OH, where I live, I would not consider anything under 11 CAP, but in Chicago, Seattle, or New   York a 4%-7% CAP satisfies investors.

I have to also say that while a 9 CAP or above typically provides for good opportunity to achieve substantial Cash Flow, a CAP Rate of 5% is too “skinny”.  People do it in “hot” markets because they are banking on appreciation – I don’t recommend this.  In my experience, a 9 CAP minimum is necessary to achieve stable Cash Flow.  Therefore, if you happen to live in the part of the country where the CAP Rates are very low because prices are too high in relationship to the rental income, it may be necessary for you to either invest long-distance, either on your own or as part of a syndicate such as mine…

Hopefully this helped some of you decipher the concepts relative to the Capitalization Rate.  I welcome your questions and comments below!

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7 Comments

  • Ryan Ebanks Reply

    It is interesting how cap rates vary across different markets, which underscores the value of knowing your market. What is also important that comes with time is knowing property – the nuances, things to look out for. Last fall I purchased a property after prudent analysis. The numbers were great, inspection ok and there was a large tree in the yard that I thought nothing of at the time.

    Got a call this week of a collapsed main line (tree roots!!!) and a large repair bill. Sure enough, my projections for 2014 have been shot

    • Ben Reply

      Haha – I hate trees!!! Of course the tenants love them – but my feelings always seem to win out…

      Thanks Ryan!

  • Willy Reply

    Ben,

    When you look at smaller properties (2-4plex) how do you establish your buy criteria when improvements are involved? Will you use an estimated NOI after you make improvements that will no doubt enhance Gross Income due to increased rent potential? And how to do you integrate the fix-up costs? It seems impractical to annualize fix-up expenditures as they would not represent normal annualized operating expenses.

    Real word example:
    I recently purchased a duplex for $250,000. It was an inheritance with the heirs having no property management experience and eventually became a short sale that I purchased. It is currently under performing the area rental market with two sub-standad tenants paying $800/mo each. With $38,000 in improvents I will realiably fetch $1400 for each unit and should easily appraise at $500,000 (coastal California) although I intend to keep it. It will also require moderately extensive roof work in 2-3 years (est. $11,000) in addition to the $38,000 fix-up needed now.

    I evaluated this property as follows:
    Price = $310,000 ($250,000 price + $60,000 repairs + fudge)
    Expenses = $7200/yr ($300/door x 12 mo) I estimated post improvement expenses
    NOI = $26,400 ( $1400/mo x 12 each unit after improvements)
    CAP = 8.5%

    Is this how you would do it?

    • Ben Reply

      Willy,

      1. I think you are making a mistake in that you are projecting the acceptable purchase price from after-repair NOI. The whole point is that you are buying the existing revenue stream and should pay a price which is a function of that existing revenue stream. Otherwise, you are not getting paid for the hard work of turning the thing around! Capitalize value from existing NOI, and then improve the NOI and drive the value…

      2. I pay around 40k per unit all in for $600/month of rent. This cash flows well. You are paying $160,000/unit for $1,400 of rent – if you get that much. That’s not going to cash flow very well, which is reflected in your 8.5 CAP (if you get that). Even though in terms of dollar amounts 250k seems like a good price, in terms of CF it is really rather skinny – and you have to spend cash on top…

      Now – if the building will appraise for 500k indeed when you have 310k in it, then you’d be crazy not to sell it for 465k and roll the money tax-deferred into something else. You live in part of the country where CF is the wrong game to be in. I am putting together a syndicate, as you likely know, to go after big apartment assets in the mid-west. I am looking at 9.5 or 10 CAP at the front door with expandability higher. I think that this is still possible – just not in your parts…

      Hope this gives you some perspective 🙂

  • Willy Reply

    Thanks for the great insight Ben. You are correct, this has very few opportunities to obtain CF property. My RE business model for the past 7 years has been to Buy/Fix/Sell SFR’s either immediately or after one year. I am conceptually familiar with multi-family and Buy and Hold principles but have admittedly little hands-on experience in that realm. They few times I have held a property were to defer the sale for better Capital gains treatment. My original intention for this Duplex was to rehab it, and put it on the market like I have in the past. After weighing my options I am reconsidering.

    I could exchange the property for something else that cash flows better however it would almost certainly not be nearby and my equity in any such exchange may not be available for business purposes.

    I could sell the property and pay (hefty) taxes on the gain.

    Or I could hold it, have it reappraised after it’s renovated and establish a HELOC as a source of low cost, future for acquisitions. A HELOC at 80% LTV should provide a source of transactional funding equivalent to post tax gains were I to sell it, with the bonus of modest cash-flow in the interim along with the potential for price/rent appreciation. After much thought the last option seems to make sense and considering the dearth of CF properties in my area I will probably go with it. I am a bit reticent to own long term holds from afar but may feel more comfortable (or not) after gaining more experience with this one.

    I do want to thank you for sharing your insight here and on BP. I intend to remodel one of my units patterned partly after you Ultimate Apartment Remodel article. I also am opening my mind to Buy & Hold properties after having learned more about them. Any additional advice is most welcome. Thanks a bunch and best of luck in your endeavors – Willy

    • Ben Reply

      Not a bad model Willy. Or, you could 1031 and roll 100k into a syndicate such as mine. If you have the time and desire to flip, you’ll do well sticking to that plan. But, in the long-run it’s a job – it builds dollars in the bank but not wealth, because wealth is a function of free time… Thoughts?

  • Willy Reply

    I completely agree with you regarding wealth. For me flipping is the only game that makes sense, saving the rare exception. I’m always looking for opportunities to grow wealth as opposed to just money. I will be keeping your syndication opportunities in mind as I grow in my RE endeavors.

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