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SHOW NOTES FOR EPISODE #024 – WHAT IS CAP RATE AND WHY IS IT IMPORTANT?
When you are an active real estate investor, you become part of a new world that can, at first, seem a bit ominous and strange — with its own culture and language – that, at first, can be a bit overwhelming. I remember, as a newbie investor, when I would be speaking with an experienced investor, broker and banker, what have you, and how, at times, it brought back memories of when my family first arrived in Haiti – a new totally different language and culture that was absolutely foreign to me. I remember nodding and mumbling “uh-huh, yep, oh of course,” and praying he wouldn’t ask me a question to demonstrate just how much of a “dweeb” I actually was. I remember, as soon as the conversation was over, immediately getting online or calling someone I knew, to try to find out just exactly what this person was talking about and why or why not it had any significance to me or what I am doing or trying to do.
Well, that is why, on some of our Fun Facts Fridays, I’m going to try to tackle some of the common real estate investing jargon and terminologies you will increasingly come in contact with – so you won’t have to grabble with this new language – especially when you are still learning and trying to impress some banker or broker that you actually know what you are doing! And trying not sound like a total novice – which I still constantly struggle with. Haha
Anyway, today’s term is one you will hear frequently from many investors, sellers, bankers, brokers and industry gurus or experts. I’m talking about the term “CAP RATE” or “Capitalization Rate.” This one, at least for me, was a bit perplexing because it can be applied to two different things – the easiest definition for me is when you are talking about the CAP rate of a particular property. That is just a matter of doing a simple mathematical calculation. And understanding what it means as it pertains to that particular property. But the other way CAP rate is used is in relation to a market – a neighborhood, city, town or even a larger region, such as a state or part of the country. This CAP rate reference is the one that was most difficult for me to grasp because it takes into consideration the average CAP rates (taking into consideration all of the properties in a given area).
A BASIC DEFINITION OF CAP RATE is – The ratio of net operating income of a property to its market value or, you can also say, it is the annual percentage return an investor would get if they purchased the property for cash (for example, if I purchase a property for $100,000 and get a net income of $10,000 – I am getting 10% on my investment of $100,000 every year. Now you know why so many people are crazy about real estate investing!
Now, before you try to grab a pen and take notes while your driving — please keep in mind, everything I say from here forward will be detailed in the show notes for this episode which are found at our website – olddawgsreinetwork.com. OK? So no need to take notes.
Let’s first tackle the CAP rate of a particular property. The textbook definition of a CAP rate for a particular property is this – “the ratio of Net Operating Income (NOI) to property asset value.” Or, The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on his or her investment.
OK, let’s stop right there. I hate when people define jargon by using more jargon. I mean – give me a break!!!! So, let’s first break this down by defining more “industry jargon.” What is the “rate of return” or Net Operating Income or NOI?
Net Operating Income is simply your Gross Income — your annual rent total plus whatever other income you may have coming in (like coin-operated laundry machine income, pet fees, parking fees, etc.) – your total income for the year – MINUS your total operating expenses.
NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.
Everyone in business or finance has encountered the term, “net income” and hopefully understands its general meaning, in other words — what is left over after expenses are deducted from revenue/income.
With regard to investment real estate, however, the term, “Net Operating Income” is a minor variation on this theme and has a very specific meaning. You might think of NOI as the number of dollars a property returns in a given year if the property were to be purchased for all cash. By more formal definition, it is a property’s Gross Operating Income less the sum of all operating expenses.
Again, excuse me for using more jargon to define other jargon.
Let’s take these two new terms one at a time:
Gross Operating Income: Definitions are sometimes like artichokes. You need to peel the layers off one at a time. In this case, take your Gross “Scheduled” Income, in other words, the property’s annual income if all space were in fact rented and all of the rent actually collected. Now, subtract from this amount an allowance for vacancy and credit loss. The result is your Gross Operating Income.
To make it painfully simple – which for me is still never simple enough.. If you had 10 apartments that rented for $10 per month each (you’d probably go broke – haha – just kidding – just trying to keep it painfully simple) – OK 10 apartments, $10 per month for rent – That’s how much per month – You got it — $100 per month. Now, multiply that by 12 because the Gross Income is an annual amount. So, for our example, your Gross Scheduled Income would be $1,200. But, when you factor in, for example a 10% vacancy rate (because in the real world, tenants do come and go you and need to allow for that). Now, take note: what you chose for your vacancy rate is a percentage that can be determined based on a property’s history, regional statistics or just your own criteria. In this example, we’re conservatively using a 10% vacancy rate So, to figure your Gross Operating Income, subtract 10% from your Gross Scheduled Income. Using our example, take your Gross Scheduled Income of $100 per month, minus 10% or $10, to get $90 per month times 12, to get your Gross Operating Income of $1,080. Get it?
Now you take that you have your gross Operating Income, subtract your Operating Expenses.
What are Your Operating Expenses?: This is the term that can be a bit confusing. Many people say, “If I have to pay it, then it’s an operating expense.” But that is not always true. To be considered a TRUE real estate operating expense, an item must be “necessary to maintain a piece of a property and to insure its ability to continue to produce income.” Loan payments, depreciation and capital expenditures are not considered operating expenses.
But property management fees, utilities, gardeners, and trash collection service are all operating expenses. Repairs and maintenance are also operating expenses, but improvements and additions (like rehab, upgrades, adding a swimming pool, etc.) are not – they are called CAP-X or capital expenditures. Property tax is an operating expense, but your personal income-tax liability generated by the property is not. Your mortgage interest may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it.
OK – Now, to get your Net Operating Income or NOI, subtract the Operating Expenses from the Gross Operating Income and you have the NOI. Yay!!! Whew!!!
NOI is essential to calculating the market value of a piece of income-producing property. That market value is a function of its “income stream,” and NOI is all about income stream. A real estate investment is not a just an assemblage of bricks, boards, electrical cables and bathroom fixtures. It is an income stream generated by the operation of the property, independent of external factors such as financing and income taxes.
Now, back to CAP Rate. CAP rate is “the ratio of Net Operating Income (NOI) to property asset value.”
The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on his or her investment.
The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property (the amount you pay for the property), where NOI is the annual return on the property minus all operating costs.
The formula for calculating the capitalization rate can be expressed in the following way:
Capitalization Rate = Net Operating Income / Current Market Value
So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
BREAKING DOWN ‘Capitalization Rate’
The capitalization rate is very useful in that it streamlines information about real estate investments and makes it easy to interpret. For example, if Stephan buys a property for $900,000 and expects that the property will generate $125,000 per year after operating costs, the capitalization rate for his investment is 13.89% ($125,000 / $900,000 = 0.1389 = 13.89%). What this means is that, every year, Stephan is earning 13.89% of the value of his property as profit.
This example assumes that all factors of Stephan’s cap rate calculations will remain constant, but in reality things often get a little more complicated. Suppose that due to a boom in demand for real estate in Stephan’s town after he makes the investment, the value of Stephan’s property rises to $2 million by the time two years has passed. Meanwhile, Stephan has been making the same amount of money from the property. Since capitalization rate calculations use the current market value, the capitalization rate of Stephan’s investment has changed. Because the market value of the property has risen while Stephan’s NOI has not, the cap rate has dropped considerably to a less favorable 6.25% ($125,000 / $2 million = 0.0625 = 6.25%).
Examples like this illustrate an important function of capitalization rates. Because the cap rate is a ratio gauging profitability, the proportion of NOI relative to the current market value must remain constant in order for the capitalization rate to remain the same. If NOI rises while the market value does not, the capitalization rate will rise and, if the opposite happens, the capitalization rate will decline. In order for a real estate investment to remain profitable, NOI needs to increase at the same rate as the property value increases, or at an even greater rate. In this respect, capitalization rate is useful because it can be used to track a real estate investment over time to see whether or not its performance is improving. If, for whatever reason, the capitalization rate is declining, it may be a wiser decision to simply sell the property and reinvest elsewhere. With a drop of over 50% in Stephan’s cap rate in just two years, he would likely be best off either finding a way to raise his NOI or selling the property and finding an alternative investment.
Uses of Capitalization Rate
Often, comparing different property investments can be like comparing apples and oranges, so the capitalization rate is a good jumping-off point because it can be used to quickly and easily compare many investment opportunities with one another. Comparing the market values or operating income estimates of various properties will often be difficult and yield results that are difficult to sift through, but comparing percentages is very straightforward.
For example, suppose Martha is considering two different investments with market values of $230,000 and $3M and estimates that their NOI values will be $40,000 and $300,000, respectively. While these investments differ substantially, knowing that their respective capitalization rates are 17.39% and 10% may help Martha make her decision. Yet, while the first investment’s cap rate is much higher, the second investment will earn much more money annually, so this will likely play into Martha’s decision as well. While this example helps illustrate cap rate’s ability to help in comparing investments, it is important to note that it is most useful in this function when either the NOI or current market value are comparable. Investments of drastically different sizes may often have additional considerations that can prevent smooth comparisons.
When seeking to invest in real estate, investors will often decide on the lowest cap rate that they will accept in order to make the investment worth their while. For example, an investor might decide that, for the amount of money they are looking to spend, they will only accept an investment with a capitalization rate of 10% or higher (that is my minimum). When looking at potential investments, then, they will compare the cap rates of those investments against their personal cap rate.
Issues with Capitalization Rate
While the capitalization rate is a very useful ratio to use when planning or analyzing an investment, it comes with a few important limitations that should be considered before using the cap rate.
One such limitation is that the cap rate is not very useful for short-term investments. With little time to develop a reliable cash flow, an investment’s NOI can be difficult or impossible to determine, thereby making cap rate calculations difficult or impossible as well.
It is also important to note that the capitalization rate is sometimes calculated as NOI divided by the original amount the current owner paid for the property. Because the value of a property will rarely remain the same for very long, this method of calculating cap rates is far less useful than the other method. Calculating a cap rate for a property with a value of $2 million in 2015 based on its 1995 price of $300,000 will not be very useful and will give very misleading results. Additional issues when using this method may also arise in the case of a property given as a gift or through inheritance, as the cap rate cannot be determined with a cost of zero.
The capitalization rate is a popular and easy ratio to use, but it should not be the sole factor in any real estate investment decision. Many more factors need to be looked at such as the growth or decline of the potential income, the increase in value of the property and any alternative investments available.
A Few Words on CAP Rate Compression
Sometimes you will hear that CAP rates are compressing in a certain area. This means that they are getting lower
“To understand the dynamics you have to think of the influences in three parts. First, there is the demand by tenants for a certain property type and location, a factor I call space demand. Then we have to consider the supply of property available for lease and how much new stock is coming on to the market,” he says.
“Finally, and most importantly, we have to factor in the dynamics of the investment and debt markets, because property’s return on investment must be seen relative to other investment avenues, particularly cash and term deposits.”
Cap rates can be a useful guide to market expectations of what will happen to values in the future but they can be bumped around by changes in investor sentiment and alternate markets.
Using CAP Rate to Determine a Property’s Value
Finally, CAP rate can also help you to determine a property’s value. Although there are other factors that may affect a property’s value, appraisers use the following formula to get a quick view of the property’s value. NOI or Net Operating Income divided by the market CAP rate.
- Determine the net operating income of the subject property the client is considering purchasing. If it’s an apartment complex, determine the net rental income after expenses.
Example: A six unit apartment project yielding $30,000 net profit from rentals.
- From recent comparable sold properties, determine the capitalization rate or ask your broker what is the typical cap rate for the neighborhood.
- Divide the net operating income by the capitalization rate to get the current property value result.
Example: Assume a capitalization rate of 11%.
$30,000 / .11 = $272,727 current value of the property.
When I am assessing multiple properties quickly – sometimes looking at 20 at a time – I will often, due to the properties I historically purchase, assume a 10% market cap rate. This allows me to do quick value assessments using this formula to see if the property is in the ballpark. I use what I call my “3 minute Rental Property Analyzer” – an Excel spread sheet where I plug in a few key numbers and it calculated CAP rate, Cash-on-Cash return, NOI and the property value. This allows me to do a very quick scan to weed through prospective properties to look for the “diamonds in the rough” that might pop to the surface.
The “3 Minute Rental Property Analyzer” is available for free at our website – olddawgsreinetwork.com.
Well, that’s it for today!
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