Every business or trade has it’s own lingo, it’s own terminology. The world of commercial real estate is no different. If you’re looking to make a switch from investing in single family homes into commercial real estate or just want to educate yourself so you can converse more intelligently with other investors or agents, my goal with this article is to explain, in simple terms, one of the most fundamental questions in commercial real estate. Namely, what is a “cap rate”?
Being comfortable with cap rates, how it’s computed, and how it impacts the price of the property is key for the savvy real estate investor. As I’ll outline below, even a seemingly small difference of 0.2% in the cap rate can mean a difference of tens or hundreds of thousands of dollars depending on the property size. This is *must have* knowledge for commercial real estate valuation. (Note: for residential property you can compute a cap rate but in my experience, it’s rare for sellers and agents to be talking cap rates.)
“Cap rate” is short for capitalization rate. The capitalization rate means if you paid all cash (no loans) for a property, at what rate would the property pay for itself? Let’s take an example. Say you find a duplex you are willing to buy for $100,000. You determine the property has a Net Operating Income (NOI) of $7,000 a year. I’ll explain NOI in detail below. To determine the cap rate, you use the following simple formula:
Cap Rate = NOI / Purchase Price (Market Value)
So, plugging in our numbers: Cap Rate = $7,000 / $100,000 = 7.0%
Voila, our cap rate is 7%. That’s it. For those of you who were not as comfortable with math, this 3 variable formula is all you need to master. (For those of you who are math inclined, you could go a step further and discount expected future cash flow streams to compare the Net Present Value (NPV) of those cash flows vs. the purchase price as another valuation method.) I’ll go into a bit more detail below on what specifically goes into the NOI, but for Cap Rates, you must know this formula cold.
Okay, let’s say we have a 50-unit apartment building located in City A and the same identical building located in City B. Let’s assume both buildings are generating an NOI of $200,000/yr.
Pop Quiz Question #1: If the market cap rate in City A is 8.4%, what is the implied Purchase Price? Answers posted at the bottom, no cheating.
As a hint, another way of stating the same formula:
Purchase Price (Market Value) = NOI / Cap Rate
Pop Quiz Question #2: In City B, the going market cap rate is 6.0%, what is the Market Value?
Know that as the cap rate decreases, the market value goes up. The first time I heard this, it was counter-intuitive. Pause here and play with some of these numbers until it sinks in for you. This is important to get. So when you hear someone say “cap rates are increasing”… technically it means the market values are declining. Ask clarifying questions if you’re not sure.
WHY CAP RATES ARE USEFUL
The power with using a cap rate, is that it allows you to compare any asset or property side-by-side, regardless of who the buyer is. For example, say Buyer A is willing to pay all cash (no loans required) and Buyer B can put down 25% and bank finance the remaining 75% — does the cap rate change? No, it does not. Their Rate of Return will be different, but the Cap Rate will be the same. Cap Rate ignores how the buyer is coming up with the funds, someone may have a rich uncle looking to invest money, another may be doing a 1031 exchange, there’s a multitude of possible scenarios, and the cap rate allows you to compare, at a surface level, “apples to apples.”
In the real world, you’re going to see advertised cap rates. Doing a quick search on Loopnet.com, for multi-family property in Dallas (where I’m currently investing), the range of cap rates listed are from 6.54% to 11.21%. In comparsion, in San Francisco (where I live), the range of cap rates listed are 3.68% to 8.0%. One can interpret this difference in rates as follows:
The lower the cap rate, the more the market values the future appreciation of the area.
Another way of saying this, is the market demands more income (NOI) for the same asset located in an area that may not be as attractive. I hope this is beginning to make sense for you.
NET OPERATING INCOME (NOI)
Okay, it’s probably time to drill into NOI a bit more. NOI is all of the income produced by the property less all of the operating expenses, i.e. all the expenses required to operate the property. Operating expenses include expenses such as property taxes, insurance, utility bills, repairs and maintenance, property management fees, employee payroll, etc.; basically any expense required to keep the property “operating.” What NOI does not include is your mortgage payment (also called debt service) or depreciation expense. [REMINDER to self to include reference to explain depreciation expense in a separate post.]
You might be thinking, “Wait a second, I need to make my mortgage payments in order to operate my property. If I don’t make those payments, the bank will foreclose and I lose my property.” And I’d have to agree with you. However, cap rates exlcude how your financing the property for the “apples-to-apples” comparison purpose we discussed earlier.
I started this post with an example of how a 0.2% difference in cap rates can mean a difference of hundreds of thousands of dollars. Let’s say, you’re looking at buying an apartment building that generates $350,000 NOI/year. At an 8.1% cap the implied market value is $4,320,998. Whereas at a 7.9% cap the implied market value is $4,430,380. The difference in market value is a whopping $109,392! This is not chump change. Which cap rate do you use? Well, that’s the key. There’s no exact science I can give you other than it depends upon many factors, including “the market”, i.e. what similar assets are selling for in the area.
Once you’ve got a good understanding of cap rates, the next level is accurately assessing the NOI for the property you are looking at acquiring. Whether or not you found this Cap Rate explanation easy or difficult, validating the NOI on an asset is even more challenging — a subject which I will tackle in a future post! Until then, best of luck with your investing!
Pop Quiz Answers
1. Purchase Price (Market Value) = $2,380,952 = $200,000/0.084
2. Purchase Price (Market Value) = $3,333,333 = $200,000/0.06