INTRODUCTION
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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