Hackensack, NJ · Member since 2008 · 49 posts · 1 vote
Hello Everyone, there's this thing with cap rates (well checking for a properties true value) that I just can't seem to wrap my brain around and wanted to hear what some of you other investors thought about it.
OK. everyone knows that the properties value is based off its income (NOI) which I got that, and everyone knows you arrive at the cap rate by dividing NOI by the Asking Price which you get the cap rate at which the seller is selling his/her property at.
so my question is, isn't it a flawed pratice to analyze all deals off a 10% return/cap calculation? because basically to me there is no set true value even when both you and seller agree on the income the property produces.
Example....a property generating 100K and a asking price of 1.4M equals a cap rate of 7. But if I were to come along and analyze this property off of a 10% return/cap this property would look like its 400K overpriced (so whose right).
I know behind all this its based on the risk factor (lower return less risk, higher return more risk), so with that being said what particular risk factors that make you investors feel comfortable analyzing the property/deals off of a 10% return/cap instead of what the seller is asking for?
the point behind this whole thread is that I feel alot of investors are missing out on some great deals because they're being taught how to analyze them correctly, so they can't get a true sense of a deal or trash.
Hackensack, NJ · Member since 2008 · 49 posts · 1 vote
17y
Chris thanks for the info, chris i also found out that my thoughts were correct.
there is no set value, the value of the property is based on what makes sense for you to achieve your investment goals (that's it).
some will say to not rely on the cap rate for your purchase decision (which i agree), but to use it to compare to other similar properties that have sold in the area, which is actually not reliable because 1. there will be less comparables, 2. how properties were purchased vary from deal to deal, 3. the inner workings of most transactions are confidential.
so the best way to analyze a deal (while using cap rates) is to add your financing terms into the picture (principal + interest and etc) and calculate what the deal is really worth to you.
see the normal NOI/Asking price = cap rate is based on if someone were to pay all cash, this is the return they could expect first year, but paying all cash for a property doesn't happen all that often (bank funding will be use for a large portion of that cost).
so i found the best way to use this formula and analyze my deals is by look at all factors but also including my financing terms with my desired return objectives into the picture to get a proper view and value to me.
Real Estate Consultant · Burke, VA · Member since 2008 · 37 posts · 1 vote
17y
Chris S,
I totally agree. The only thing that I would add is the following and maybe this will clear up a few things for the initial questionaire Chris J:
1. The Cap Rate is nothing more than a ratio. Its a useful number for comparing comparable property types in the same class. The number will vary widely across different asset classes. As Chris S suggests this is how one goes about determining risk. Its just a simple means of finding the properties current yield.
2. The Cap Rate is an indicator of how profitable a property is before leverage. I suggest that the cap rate that you use be at least 2 points higher than your expected interest rate (blended or otherwise) because this provides a cushion considering financing and other factors.
Chris J there is no real need to modify the formula as it is important for comparison reason and back of the napkin calculations. and there are so many other things to consider when analyzing a property.
Real Estate Investor · Seattle, WA · Member since 2008 · 34 posts · 6 votes
17y
Cap rates are barely useful to a real estate investor other than a very initial analysis. So much depends on what you are trying to do, what will happen with the property after you buy it, what your cash flow requirements are, what appreciation is like in the area, how much you plan to put down, etc..
You need to analyze every property more fully and look at the actual cash flow and returns and make sure it meets your requirements for the amount of risk involved. that is what will determine how much you are willing to pay for the property. If it does not meet your investment criteria, then it does not matter what the cap rates for the area are, whether the broker tells you its a good deal because its slightly higher cap than other recently sold properties, etc.. none of that matters. The only thing that matters is the return on investment that you need/expect to get for the property type in question and that the sale price will give it to you. If not, then walk. You can not find that out by looking solely at the cap rate.
this may mean that you have to adjust your expectations about how much of a return you can get, or that you need to find a different city to invest in or different financing strategy, but at the end of the day, its the return that matters and the cap rate will simply not tell you that.
The cap rate is little more than a sales marketing tool. brokers will often become obsessive about it when they are trying to sell you a property. But do not let them talk you into paying more for a property unless your investment return requirements can still be met through some kind of creative financing or realistic strategy. If you can't meet those requirements and the seller can't accept a high enough cap rate to make a deal with you, then walk. There are lots of deals out there. Keep looking. Be prepared to adjust your expectations as well.
What someone else said about the cap rate being 2% over the loan rate is a good gauge, but you may find you are missing out on some deals you could have made happen through some creative financing with the cap rate lower, so don't get too locked on that idea. But in general, if you want cash flow, then 1-2% over the bank interest rate will give you a solid cash flow with a reasonable down payment and solid ROI as well. However, lots of people invest in certain cities with lower cap rates, even below then bank interest rate. They have to put more money down in order to make sure it cash flows and they depend on appreciation or value plays to make the overall investment workout for them in the end. It just all depends on the property, the financing strategy, the exit strategy and everything else. You simply must do a full analysis, there is no easy way out.
But if you're like me and you know that you only want to invest in certain types of properties using only certain types of strategies in terms of financing, then you can probably zero in on the type of cap rate that you know you need to get, relative to the loan rate and use that as a rough guide for quickly evaluating new properties as they come to you.