06
Jul 2011

Investors Commonly Misunderstand Cap Rates

By mshaw839

In our day to day business we deal with many apartment owners, multi family investors, single family rehabbers and even some commercial office owners.  The other day a new smaller investor was in our settlement room and was speaking about how great his rate of return was on his upcoming purchase.  He was using cap rates to compare some current and future investments of his.  It made me realize there is a genuine lack of understanding by many on the phrase “cap rate” and I figured I would blog about its use in more detail.  Of course we are no investment experts and are only your resource for title insurance, but we hate to see clients with a fundamental misunderstanding of something that should be basic.  Especially if they plan on investing!  Hope this is useful…

First, looking at a capitalization rate, as the only measure of an investment property is silly unless it is compared to the market capitalization rates for comparable properties. When looking at such comparables, be sure to compare apples to apples.  A Class A property is much different than a Class C property even if it is right next door.  Moreover, any investment property four units or less should not use a capitalization rate calculation, but that is a different discussion to begin with. In many ways the numbers would be meaningless.  Perhaps a future blog post on the gross rent multiplier equation would be helpful…

Ok, so what is a Cap Rate?  The “cap rate” of an investment is a percentage used to estimate the value of income producing properties.  A cap rate is determined by the net operating income divided by the sales price.  Many investors, banks, and appraisers use cap rates to estimate the purchase price or value of income producing properties.  A realtor or appraiser may even look at comparable properties recently sold to formulate a market cap rate in a specific market.  This allows their client or the bank a dependable estimate of value.

Cap Rate = NOI/Market Value          Estimated Market Value= NOI/Cap Rate

For example, let’s say an investor is looking to purchase a multifamily property as an investment.  The investor sees a property listed for $1,000,000 and identifies it for a potential bid.  To determine what his rate of return would be on the investment we need to predict or find out certain variables that make up the NOI (Net Operating Income).  In short NOI= gross income minus vacancy allowance and operating expenses.

So for our example let’s utilize the following:

Per Month

Gross Rents……………………………………………………………..13,000

Other Income (laundry coin operated machines, etc.)…    100

Minus Vacancy (for these purposes lets use 5% of gross rents, meaning that 5% of annual potential rents will not be collected due to vacancy)

Vacancy (5%)………………………………………….     870

Minus (expenses)

Water/Sewer; Common Electric; Gas………………….    350

Other Maintence Reserves…..…………………………    300

Management……………………………………………   750

Insurance……………………………………………….    300 monthly

Property Taxes………………………………………….   600 monthly

Gross Income………………………………………….13,100.00

Vacancy Allowance…………………………………….   870.00

–          Operating Expenses…………………………….2,300.00

——————————————————————————

Total……………………………………………………11,230.00 * 12 Months = $119,160.00

119,160/1,000,000 = 11.9 Cap

Sometimes an investor may see a property and be able to predict what he/she will be able to do to the property to create a certain NOI.  If such investor knows what their rate or return needs to be they can simply take that NOI and divide the return they wish to have, this will provide them the purchase price they are willing to spend on that such given property.

Example – 10,000/.10 = 100k.  So if the NOI was 10k a year and the investor was compiling investments that would provide him with a 10% rate of return, he would be willing to spend up to 100k for said property.

Obviously investors desire a larger rate of return when investing riskier assets.  The cap rate may vary in different areas for various reasons such as location, crime, infrastructure, long term vision of the area, etc.  Investors jump all over properties with high cap rates in desirable areas, similarly investors will shy away from lower cap rates in unattractive areas.

In the perspective of a buyer and seller and the relative cap rates, sellers are trying to get the highest price for the property or sell at the lowest cap rate possible.  A buyer wants to purchase the property at the lowest price possible which means a higher cap rate.  The lower the selling price the higher the cap rate and vice versa.  From an investor’s perspective, the higher the cap rate, the better the deal.

As far as what is going on today, continued historically low interest rates have allowed investors to refinance to more favorable terms. Although there were many large write-downs when the cash-pocalypse hit, most commercial real estate borrowers have had the cash flow to keep loan payments current or refinance to buy more time.  Some savvy bottom feeding investors have jumped in full throttle over the last 24 months taking advantage of rock-bottom pricing and low interest rates.  With many would be home owners sitting on the sidelines there is a larger demand for rentals, this rising demand has essentially pushed down capitalization rates.

Just keep in mind capitalization rate calculations are only one tool in evaluating real estate and without the proper information the numbers can be somewhat misleading. Use the cap rate with other calculations and cash flow analysis in order to really analyze whether the subject property is a good addition to your investment portfolio.

For those interested take a look at the following magazines which provide free subscriptions and are very good for multifamily investors…

http://www.multifamilyexecutive.com/toc/the-magazine.aspx

http://www.multihousingnews.com/manage-subscriptions/