Seriously, people – this is one of the most misguided questions I can think of in the real estate investing space. And yet, here it is, the title of my article 🙂
Well, as you know, my articles reflect your questions, and therefore it follows that the reason this article came to be is because so many people ask this question. Does this mean that many people are misguided? Yes; yes it does.
So let’s see if we can help it some…
One caveat I need to preface with is that I have no intention of cramming three hour’s worth of a discussion into this article – I did that and more in the Cash Flow Freedom University. All I mean to do here is cover the key highlights and point you in the right direction.
What Is Cap Rate for Real Estate Investment?
Cap Rate stands for Capitalization Rate. Capitalization Rate is a metric that describes the rate of return at which an investor in a specific marketplace is willing to put capital at risk by buying a specific type of an asset.
Notice, guys, this is not a metric specific to a particular investment. Rather, this is a metric that describes the marketplace itself, at least relative to investor behavior.
Cap Rate vs CMA (Comparative Market Analysis)
This may be easier to understand for some of you if I draw a parallel to a Comparative Market Analysis (CMA). In the single-family residential space, the CMA is used to estimate value of houses. The basic premise is that the analysis looks at other like-properties which have sold in close physical proximity as the basis, and then adjusts the price for which they sold according amenities and condition in order to arrive at an approximate value of the subject.
Since income property is bought not to live in, like an SFR, but because the buyer is really buying the income stream represented by the property, Cap Rate looks at rate of return sold properties are getting for the investors, and based on that establishes the level of appetite and assessment of risk-reward in the marketplace.
Notice – we are talking about the marketplace here. We are not talking about specific assets, and this is an important point. You have likely been taught that Cap Rate is a metric that describes the performance of a specific asset, and while there is some truth to that, it is only half true. Cap Rate is indeed a market-driven metric, which describes the behavior of the marketplace. The way it applies to specific asset is only to place that asset into the fabric of the marketplace for comparison’s sake.
How Do We Use Cap Rate
Capitalizing value of income property is basically answering the following question:
If I were willing to deploy capital so long as I were going to receive a 10% return on my money, how much would I be willing to pay for this property which produces $xyz income?
So, if the property is generating $10,000 of annual return relative to NOI (we’ll talk about the Net Operating Income another time), and we are willing to pay a function of 10% Cap, then we should be willing to pay $100,000 for this property… $10,000 is 10% of $100,000. If, on the other hand, we were only willing to deploy capital if we receive 20% return on our money, then the NOI of $10,000 would be worth $50,000. And so on…
The formula is: Value = NOI / Cap Rate
How Do I Know What’s a Good Cap Rate
There are a couple of things to this:
First – I already told you that Cap Rate is a metric that describes the marketplace. As such, you don’t really have a say in what is good or bad Cap Rate – it is what it is in each specific marketplace.
The application, therefore, is now that you know what the rest of the marketplace is thinking (because you know the prevalent Cap Rate in that marketplace), you can build a strategy around a specific asset which would outperform the marketplace averages. And you only buy those assets which represent opportunity to do exactly this – outperform the marketplace averages. The name of this game is Value Add!
How Value Add Works in Multi-family
The value if income property is a function of 2 basic factors:
- The NOI
- The Capitalization Rate
If we know these two elements, we can use them to capitalize a value of an asset, just as I described above. Important to understand is that only one of these is in your control – the NOI. You can’t do anything about the Cap Rate; you are not more powerful than the marketplace collectively. The good news is that you don’t have to.
If you buy NOI of $20,000 at 10 Cap you will pay $200,000.
What Happens When You Improve Cap Rate?
If you turn around and within 24 months improve the NOI from $20,000 to $24,000, then at the same 10 Cap you property should be worth $240,000, and you’ve created $40,000 of value – congrats!
So – value add in the income-producing space is a function of the delta in the NOI. It is very difficult to be able to buy below the value set by the marketplace. You are going to have to pay a fair price; it’s competitive out there. But, this doesn’t mean you can’t put equity on your balance sheet by outperforming the other guy and driving higher spreads.
So – What Is a Good Cap Rate?
That doesn’t matter as much as you think. Why – because it’s all about the NOI. You can buy at 5 Cap, improve the NOI, and sell at the same 5 Cap for a bunch more money. And, you can buy at 10 Cap and do the same. It’s all about the delta!
Sure, there is a point at which cash flow becomes scarce, which is about 8 Cap. But, you shouldn’t be making your buy decision based on Cap Rate anyhow. Your buy decision should be based on Value Add – period!
Much more can and should be said, but this is enough for today.
Feel free to leave your comments below.