by Theresa Bradley-Banta
A good friend of mine recently finished reading my book Invest In Apartment Buildings Profit Without The Pitfalls.
The first thing he said was, “I loved it! What great information and what an easy read!”
Then he said, “For the first time ever I finally understand what cap rates are and how to use them.” Let me point out my friend is a very successful multimillionaire business owner.
With more single family real estate investors moving into multifamily investing than ever, I’m hearing the question, “What is a cap rate?” almost daily. Cap rates can be really tough to understand. Yet they are very simple at the same time.
Here is an excerpt from my book that will provide clarity on this seemingly complex issue.
*** Keep in mind as you read this that understanding cap rates is not rocket science—it’s just basic math. ***
Let’s start with a quick refresher on Net Operating Income (NOI)
One of the advantages to investing in apartment buildings and multifamily properties is that when you raise the Net Operating Income (NOI) on a multifamily property you can also raise the value on the property.
NOI is simply the total property income minus the total property operating expenses. Mortgage payments (a.k.a. debt service) are not included when calculating NOI. In the example below, if you have a NOI of $100,000, at a cap rate of 8% your market value equals $1,250,000.
$100,000 / .08 = $1,250,000
If the cap rate stays the same and you raise your NOI by $20,000 you will increase the market value of your property by $250,000 as shown below:
$120,000 / .08 = $1,500,000
Simple formula. Simple math.
What is a Cap Rate?
A capitalization (cap) rate is simply your assumed, unleveraged rate of return (cash) before mortgage payments and income taxes. Let’s take a look at three quick formulas. The first one you already know from the example above.
NOI divided by Cap Rate = Market Value
($120,000 / .08 = $1,500,000)
NOI divided by Market Value = Cap Rate
($120,000 / $1,500,000 = .08)
Market Value times Cap Rate = NOI
($1,500,000 x .08 = $120,000)
When you know two of the three factors, Cap Rate, Market Value, and/or NOI, you can arrive at the third. When buying a property a higher cap rate is better. Using the same math from our property above a NOI of $120,000 at an 8% cap equals a market value of $1,500,000:
$120,000 / .08 = $1,500,000
But at a higher cap rate, say 10%, the market value decreases by $300,000:
$120,000 / .10 = $1,200,000
As you can see from the next example when selling a property, a lower cap rate is better. In this example, the market value is two million dollars at a 6% cap rate:
$120,000 / .06 = $2,000,000
Remember cap rates are not the only criteria to use when evaluating a deal. Cap rates are the most commonly used criteria for screening commercial investment properties but they are not perfect. Don’t find yourself valuing a property on the cap rates your broker or seller uses. Remember most investment summaries are based on proforma numbers and they are based on frequently inaccurate NOI. Again, do your homework.
Use caution when using a cap rate as a determining factor when buying a property. Beware that in some instances and locations a high cap rate could be an indication of a high-risk property such as poor location or poor building quality.
A cap rate projects a rate of return assuming an all cash purchase. It does not include financing. When financing comes into play it becomes more complex to arrive a rate of return.
I guarantee you that when you own a property you will watch your market cap rates closely. If for example you bought your property at a cap rate of 6% and the market realizes upward pressure on caps (i.e., they start to rise), you will take notice. You can see your property value drop before your very eyes as shown by the math above.
This is another reason why one of my real estate investing money rules for any type of real estate is, “Always make money on the front end of the deal.” Unless you plan to hold your real estate acquisitions for the very long-term and you are not relying on your investment to bail you out financially if you encounter bad times, you must buy at a price that makes you a profit today. In other words, you’ve got to find good deals.