Capitalization Rate: Simple Explanation, Calculation, Application
If you intend to master multifamily or commercial real estate investment, you’re going to need a clear understanding of how Cap Rate works.
In this post you’ll:
- learn what Cap Rate is, and a simple trick to remember and calculate it;
- discover how to find Cap Rates for where you invest; and,
- see a practical, almost magical, way to use it.
Plenty of really smart people get tripped up on Cap Rate. This post will enable you to explain it to them in terms they’ll understand.
WHAT IS A CAP RATE:
Cap Rate (short for Capitalization Rate) is primarily a measure of market sentiment — a starting-point or rule-of-thumb. A Cap Rate levels the playing field by linking an asset’s Value to the Income it produces.
The ‘IRV model’ is a simple way to remember and calculate Cap Rate.
Net Operating Income (NOI) is revenue, including rent, laundry, parking, or pet fees, etc. less a vacancy allowance and expenses such as property tax, insurance, maintenance, utilities, and management. NOI is the line marked ‘NOI’ on a property’s income statement; note that it comes before debt servicing.
Capitalization Rate is expressed as a percentage or in decimal format. Be sure to compare apples with apples. Is the cap rate based on data from recent sales; is it implied by an asking price; or a projection made up by a broker trying to sell you something?
Value is the price an asset has sold for, or might sell for, given its income and appropriate cap rate.
The example in the video is: $150,000 (NOI) / .05 (Cap Rate) = $3M (Value).
Assuming your numbers are true, one year of income equals 5% of value.
The best way to retain new knowledge is through practice; you’ll discover how little changes can make a big difference.
Cap Rate is influenced by: asset type; age and quality; location; rent security; and other macroeconomic factors.
Generally, a high Cap Rate indicates higher risk, and lower relative price, and a low Cap Rate suggests lower risk or greater confidence of future performance and investor-willingness to pay a higher price relative to income.
Which is better: a high Cap Rate or a low Cap Rate? Well, that depends on your risk tolerance and what you plan to do with the asset…
Let’s assume you just inherited $10M and you’re extremely risk-averse. While there’s no such thing as a completely risk-free investment, government-backed securities are reasonably close. You’ve learned that you can get a 2% return on T-bills; that’s $200,000/year. Why would you risk your $10M on a building, at a 2% Cap Rate, that may or may not generate $200,000/year and would definitely require time and attention? The difference between a safe rate of return and expected return from a riskier asset is called a ‘risk premium’.
Now, let’s assume you’re a savvy investor with considerable experience in a particular niche. You know you can acquire the asset with a fraction of your $10M by using leverage. You’ve calculated the costs of borrowing. You’ve considered the cost and benefits of investing additional capital in improvements, and you have a plan to implement a variety of operating efficiencies with the intent of boosting income and value. You might have a different perspective.
Cap rate is about the property; not the people buying it or what they plan to do with it.
Remember, Cap Rate is just a starting point; you’re buying a labour-intensive stream of income and you’ll need to do extensive due diligence.
WHERE TO FIND CAP RATES:
Here’s a practical — almost magical — way I sometimes use Cap Rate…
If I’m training or coaching a new resident manager or leasing agent, one of the very first things I do is tell them about ‘IRV’. If you believe, as I do, that their job is to protect or improve the value of your asset, then wouldn’t it be a good idea for them to know how to do that?
After showing them ‘IRV’, I’ll say something like: “If you could find a way to earn an additional $10 of income from each tenant in this building, what would that do to the value of this asset, assuming a market Cap Rate of 6%?”
$10 x 150 units x 12 months / .06 cap rate = $300,000
Wow! Someone who could do that for you would deserve a generous bonus, don’t you think?
Compare that with a manager who tells you their job would be easier if you discount rents by $50. Do the math and you’ll discover that would represent a loss of $1.5M in value!
Who would you rather have stewarding your investment?
“Big doors swing on little hinges.” ~ W. Clement Stone
Find the full video presentation here. There’s more to learn about Cap Rates. Please reach out to me if you need help.