How does the Cap Rate Work

[Daniel P Willis]

So I have a single family home and a trailer that I rent out and my wife and I are looking at purchasing a triplex or quad. How does the Cap Rate work and at what time does that become relevant? I always try to learn as much as I can before making an investment and most of the forms that i've seen just say that cap Rate isn't something you have to worry about until its a commercial property. Why is this, why doesn't it matter and how does it work? 

     Any help is much appreciated, I would also like to know your experience with using Cap Rate and how it helped you in your investment, if its not to much trouble. 

   Thank you. 

[Reed Schlesinger]

Originally posted by @Llewelyn A.:

@Brent Coombs Let's look at an example. You are buying a property for $100k and it has an NOI = $10k (rents minus expenses excluding Debt Service). The Cap Rate is = NOI / Purchase Price (PP) = $10k / $100k = 10%. Let's say that's inline with the Market Cap Rate.

Now, you but the property and then you go to the County and fight and win a reduction of your Property Tax by $1k. Your NOI increases by the same amount of the Property Tax reduction now = $11k.

We now have to look at the valuation of the property you bought by calculating the Selling Price in relationship to the Market Cap Rate.

To Sell the Property at 10% Cap, PP = NOI / Cap Rate. So the new PP = $11k / 10% = $110k. Effectively, you increased the value of your property by $10k if you lowered your Property Tax by $1k.

I also wanted to expand on the Concept of Moving Cap Rates.

Depending on certain factors, the Cap Rate for Cities and Neighborhoods in Cities will move.

A typical example is when crime increases in a neighborhood.

If Crime increases over an extended period of time, years for example, investors will demand a lower price for the investment given the same NOI. Thus increasing the Cap Rate to compensate for the higher risk.

Similarly, if a neighborhood improves, the price of the property rises even if the NOI does not increase very much. This can be due to the perceived desirability from people just wanting to live in the neighborhood. This effect happens a lot during a period of Gentrification in Metropolitan areas.

What I tend to do is to buy in area where the Cap Rates have a distinct downward trend. Before of the above formula, PP=NOI / Cap Rate..... keeping the same numbers.... let's say that the Cap Rate for a neighborhood is currently at 10%. However, because Gentrification, we know from history of other neighborhoods that the Cap Rate is most likely to fall, and probably to 5% as other comparable neighborhoods are at 5%.

We can then do a Future calculation to determine the amount of Appreciation of the Investment.

For a property that you are buying at $100k with a Cap Rate at 10%, we know that IF the Market Cap Rate falls to 5% and NOI stays the same at $10k.... we will get the following Calculations.... Current calculations is PP = $10k/10% = $100k. When the Cap Rate falls to 5%.... the new calculations will be PP = $10k / 5% = $200k.

While all of this is fairly obvious, I think Investors need to do these calculations to get an intuitive feeling on how their Investment's future value may be affected.

You really want to invest in neighborhoods where the Cap Rate is MOVING DOWNWARD and NOT UPWARD.

If you have a good understanding of the surrounding neighborhoods and their cap rates and understand the history of those neighborhoods and their cap rates.... you can almost "feel" the Cap Rate as it moves along the wave.

Yes, it's probably way too much information! I realize that.... but after all these years as an investor who watches these things, I really get a clear sense of where to invest (or where to stay away from) and what neighborhood to target based on the wave of the Cap Rate movements.

Hopefully this helps in some way to the reader of this post!

Investor Llew

Great analysis!

[Matt R.]

Originally posted by @Daniel P Willis:

@Llewelyn A. Thats a good experiment to try, especially if you were able to use that to justify a higher price, that might be a fun/interesting/possibly beneficial experiment to try. 

Thanks everyone thats great!

Right on. I think the important part is the direction of the cap like Llew mentions. So the next time some seller mentions cap.. the next question should be, cool,  how did you arrive at that number? What was that areas cap 3, 5 and 10 years ago?  When these jokers who are pimping the caps on single family homes as reasons to invest that is really when these questions could come into play. Still the State of Calif courts recognized RE cap expert was stupidly lost by BP...and this forum should not forget that idiocy either. 

[Llewelyn A.]

@Bryan Hancock Interestingly enough, but I find 95% of most investors don't account for the time value of money or the Future Value of their Assets. These calculations should be tools in the Investor's tool chest. But unfortunately, they are not for the vast majority of Investors.

In regards to Residential Comps, I find that a lot of times that the Comps are incorrectly used or that the target property for purchase is incorrectly evaluated.

I've used that type of situation to my advantage several times.

This is a real life example that had occurred to me.

I saw an ad for a Three Family building 2 doors down from my building which is a Four Family. 

From the Facade, both my building and this building were exactly the same stories and similar dimensions.

I immediately called the Real Estate company and asked to see the property.

When I got into the property, I immediately when to the BASEMENT. Why?

Simple.... in NYC, you cannot NORMALLY have more GAS meters than the LEGAL Occupancy of the building (only very rarely will an apt not conform to this and the exception tends to be a separate Gas meter for a heating unit for the building).

There were exactly 4 Gas Meters.

Once I had seen that.... I immediately went to look at the number of Electric Meters. Similarly.... you MUST have the same number of Electric Meters as the number of LEGAL Occupancy of the building, with the one exception of a Common Meter.

There were exactly 5 Electric Meters.

That was all I needed to know. I did my analysis which normally included an Intern Rate of Return (IRR) over a 10 year basis, then proceeded to look at the rest of the building. I used the 4 Unit for the Analysis since discovering the inaccuracy.

The following day, I submitted my offer for the building at ASK and proceeded to buy the building which closed 2 months later.

The Seller did not know that her building was actually a FOUR Unit building rather than a THREE Unit Building. She bought it as a Three Unit and just never knew.

The Appraiser didn't know either. All the Appraiser did was looked at the number of kitchens which had 3 kitchens. One of the apts was a 2 level apt, but that did not conform to the Certificate of Occupancy that I later pulled from the Buildings Dept.

After I took possession of the building, I immediately threw together a kitchen on the floor which was missing one in the 2 level duplex apartment.

Then I called for a re-appraisal in order to take out a second loan on the property.

The results of the 2nd appraisal was $400k more because it had to Comp against 4 Family Buildings versus 3 Family Buildings.

When you have enough experience, at least in large Metro areas like mine, and get to really know what goes on, you start to know that even things like Appraisal Comps are inaccurate.

This wasn't the first time it had happened as well.

Other cases you will find that an appraiser Failed to know that a Comp was sold to a relative, which should have been throw out.

There are a lot of these kinds of inaccuracies.

HOWEVER, if you can start to understand how Appraisals are done, you should start to learn about the inaccuracies and take complete advantage of it like I did above.

Appraisals also contains 2 other analysis other than just Sales Comps. They should also contain an Analysis by Replacement and an analysis based on Income.... which is sort of like the Analysis I did with the Cap Rate and Purchase Price.

Generally, because most Appraisers I have encountered really don't understand it themselves, they generally conform the Replacement and Income analysis to the Sales Comps. What's the whole point on doing that? Well.... that inaccuracy is something I can absolutely take advantage of, and did.

So, in this case, my own Analysis of the Purchase Price using the Cap Rate versus the Sales Comps proved to be much more accurate.

In fact, I made $400k more ON PURCHASE because of my PP to Cap Rate calculations and discovery of the inaccuracy of the Building Occupancy discrepancy.

None of this is as easy as I make it.... but if you take the time to learn and stick with it.... you can be rewarded for your efforts.

Investor Llew

[Andrey Y.]

Originally posted by @Rosston Smith:

The higher it is, the better. It helps you compare apartment / commercial buildings.

 Thats quite WRONG. Please stop spreading misinformation.

[Andrey Y.]

Originally posted by @Brent Coombs:

@Llewelyn A., you wrote: (hmmm, nope, nothing useful yet on this thread, surprisingly)...

 Brent, its quite interesting that you seem to dislike the two (out of few) people on this website that actually understand the definition of "cap rate". I wonder if that is a coincidence? Or maybe someone just needs to read up on this concept.. ;) Just a thought. Have a good one!

[Brent Coombs]

Originally posted by @Andrey Y.:

Originally posted by @Rosston Smith:

The higher it is, the better. It helps you compare apartment / commercial buildings.

 Thats quite WRONG. Please stop spreading misinformation.

He's already admitted in this same thread that he was wrong with that statement. 

No need for you to rub it in! @David Faulkner is our resident "cap rate grouch" for this thread...

[Brent Coombs]

Originally posted by @Andrey Y.:

Originally posted by @Brent Coombs:

@Llewelyn A., you wrote: (hmmm, nope, nothing useful yet on this thread, surprisingly)...

 Brent, its quite interesting that you seem to dislike the two (out of few) people on this website that actually understand the definition of "cap rate". I wonder if that is a coincidence? Or maybe someone just needs to read up on this concept.. ;) Just a thought. Have a good one!

"Dislike"? Nope. I respond to comments - and try to add value or seek clarification.

I trust you can start doing the same - without spreading unjustified personal accusations? Thanks...

[Andrey Y.]

Originally posted by @Brent Coombs:

Originally posted by @Andrey Y.:

Originally posted by @Brent Coombs:

@Llewelyn A., you wrote: (hmmm, nope, nothing useful yet on this thread, surprisingly)...

 Brent, its quite interesting that you seem to dislike the two (out of few) people on this website that actually understand the definition of "cap rate". I wonder if that is a coincidence? Or maybe someone just needs to read up on this concept.. ;) Just a thought. Have a good one!

"Dislike"? Nope. I respond to comments - and try to add value or seek clarification.

I trust you can start doing the same - without spreading unjustified personal accusations? Thanks...

 Read what you just wrote to David. Clearly condescending and antagonizing. Value added = zero. It takes a troll to know a troll matey.

Its justified. You did not treat David nor "Bob" with respect when they alluded to the useful definition of a cap rate. Why dislike the truth when it does not align with your personal beliefs. Anyway, its a beautiful day today. Lets go invest in real estate and help people :) Take care.

[Brent Coombs]

@Andrey Y., sure, sometimes I'll respond in kind. I certainly don't believe David has taken any personal offense to my (impersonal) comments. I trust you haven't either - as I haven't for yours!

Can you see where using words like: "you seem to DISLIKE the two (out of few) people on this website that actually understand the definition of "cap rate"" - overstep the mark?

[Apparently, "Bob" took too long to get that.  So although I didn't take issue with him for writing words like: "Brent must be the most clueless poster on BP" - I suggest YOU resist similar]...

[George P.]

Originally posted by @Brent Coombs:

Originally posted by @Andrey Y.:

Originally posted by @Rosston Smith:

The higher it is, the better. It helps you compare apartment / commercial buildings.

 Thats quite WRONG. Please stop spreading misinformation.

@David Faulkner is our resident "cap rate grouch" for this thread...

 lol

he's like a kid that says "i'll come to the playground with my toys, but wont play with them".

[Mike Dymski]

I'm a bean counter; so, fights over a financial metric are a dream come true.  And to boot, The Accountant is hot at the box office.

Cap rate = NOI/market value

Un-leveraged return on investment = NOI/purchase price (often confused with cap rate)

As others have mentioned, cap rates are applicable for commercial properties 5+ units and 1-4 families are valued using comparable sales.  It's fine to calculate the un-leveraged return on investment for 1-4 families to benchmark across property classes.  It does not matter what you title the metric in your spreadsheet.

There are ways to discuss this without discouraging new investors from posting and subsequently supporting the site with memberships.

[Llewelyn A.]

@Mike Dymski  In my experience in regards to Appraisals and Purchase Price, the funny part about Market Value and Purchase Price at the time when the property is actually purchased, almost ALL of my Appraisals come in about the exact same price.

Part of this is that the Appraiser demands the Contract and knows full well the negotiated price. He is obviously biased at that time.

What is even worse is that Appraisals can be so incorrect that it defies logic. Here is an example of one done on a RE-Appraisal of one of my properties for a RE-Finance, NOT A PURCHASE.

Just recently, I have a property that should have Appraised for over $2 Million. However, the Sales Comp that was used had egregious errors to be used as Comps.

For instance, while the Sale Price of on Comp was only $1.2 Million, the Mortgage that was taken out on the property was approximately $1.8 Million. This is an obvious error either during recording of the deed or that it was an non-Arms length deal where the Buyer received a large Equity Value as part of the transaction.

The other two Comps were equally as bad.

 Maybe it's just NYC fast moving Gentrification... I'm not 100% sure why Appraisers cannot seem to give a good Appraisal except when they have the Contract and it seems to me that they purposefully try to make the Market Value exactly as the Purchase price.

Honestly, if the Appraiser never knows the Contract Price, then he can do a more independent analysis.

Obviously, if the Appraisals come in at the same as the Purchase Price, which implies that the PP is the Market Price, the Cap Rate and the Un-Leveraged ROI are pretty much the same value.

I'll be curious to know if others have experienced if their Appraisals are coming out with the same Value as the negotiated Price upon purchase.

Also, what about the Appraisal Price for a Re-Fi. Do they come up inaccurate for others as well?

[Mike Dymski]

@Llewelyn A. the actual transaction itself is many times, but not always, a good "comp".  It also becomes a comp for future transactions.

Appraisers are estimating a range and they take on risk with their valuation.  This inherently leads to more conservative valuations, especially if the analysis suggests a value higher than the purchase price.  In this case, there is no need for them to take on additional risk and set a value higher than the purchase price.  If the value is borderline relative to the price, they may be able to take on acceptable risk, within their professional guidelines and the range of acceptable values, and use the purchase price here as well.  They won't get any business if they under-value all the time.  Human nature can trump the math.

I had a residential appraisal last week where all the comps were around $110/sqft and they valued the subject property at $91/sqft. And there was one comp (that was not a comp) at $70/sqft. REI takes a lot of patience.

The concern I and some investors have with commercial appraisals in refinance situations is the large gap that can occur in the use of standard costs versus the actual costs of the subject property (or at least some selection of a figure in between the two).  An efficient operator will not always get credit in a refinance for operating their property well.

[Mark Smith]

@Llewelyn A. I'm currently going through the EXACT same thing, except on a purchase.  Last week, I just received an appraisal for a property I'm purchasing.  I sent an email to my mortgage consultant with a few questions about how the appraiser got to that amount.  

Just yesterday I received another copy of the appraisal from the same appraiser, this time 20K higher and almost exactly matching the purchase price.

Clearly not an exact science, but it would seem that the bank wants to justify the amount they're lending.  Not sure what the appraiser's motive is other than wanting to receive repeat business from the banks.

[Llewelyn A.]

@Mike Dymski Yes, absolutely Correct after thinking about it. The Appraiser appraises within a Range and also protects his job by not going too far from that Range.

HOWEVER, the interesting thing is that the Appraiser does NOT appraise for you, the Buyer. It's for the Bank who is loaning the money for the purchase on your behalf. The Bank, while doesn't choose the Appraiser directly anymore these days for Conventional loans (probably the Bank has a better leeway for choosing an Appraiser when it comes to Portfolio loans, etc.) because of the perceived collusion between Bank and Appraiser in the Financial Crisis, still depends on the Appraisal in order to make the decision to lend so that it fits within their required LTV.

This presents real problems.

First, the Buyer generally pays for the Appraisal. If the Buyer pays but the Bank is the one that needs it, this gives a false sense that the Appraiser works for the Buyer. Really, the Bank should pay for the Appraiser.

Second, because the Appraiser actually works for the Bank, the Appraiser has no incentive to honestly and accurately evaluate the Market Value of the Property beyond the Purchase Price.

This means that if you wanted to do a Re-Fi or to tell the Bank that you are buying a property at a lower LTV and therefore qualify for a better Rate, you are out of luck.

The system works unfavorable to Buyers. If we had the real appraisal and the Market Price, then the loan terms would be more accurate and you would have better Investors and Buyers because they would have the incentive to buy properties undervalue if merely for better Loan Terms, which can affect the Investment substantially in the Long Term.

@Mark - Yeah, Just read your post right after I posted this. It's frustrating but unfortunately, no way to change the system. Banks and Appraisers don't even want to make the adjustments when you give them legitimate Comps.

Anyway, this is just a bit of Venting at the system.

[Rosston Smith]

Originally posted by @Andrey Y.:

Originally posted by @Rosston Smith:

The higher it is, the better. It helps you compare apartment / commercial buildings.

 Thats quite WRONG. Please stop spreading misinformation.

 You're quite WRONG. Please stop spreading misinformation.

[Michael Lee]

Hello and welcome to this website!  Yeah the cap rate is just a "rule of thumb" that is used mostly for MF properties.  It is one of several formulas that are used for value of a property.  You do need to know if the trend is up or down.  But is just a "rule of thumb" to be used when you are determining the value substantiality of a property.  Thank you for your clear explanation and good luck to you!

[Jason V.]

@Daniel P Willis Welcome to BP! Cap Rates, put simply, are a representation of the ratio of expense to income at which investors are deploying capital in a market. Too obtuse? The fondly remembered (by some) Bob Bowling put it this way, once upon a time:

"But remember the REASON cap rates decrease is because the real estate is more attractive.

If you remember the TV show "Name That Tune" the contestants were given a clue about the song (market knowledge) and then to get the prize (property) they had to bid (cap rate) on how few notes they would have to hear to identify the song. If they bid three notes but couldn't name it they lost. In real estate it is pretty much the same. Multiple people want the property. One say I can make a profit on that property at 7% cap. Another says I can make a profit paying a 6% cap. Then the first guy can go lower or tell number two "OK, take it at 6% and see if you can profit because I won't take the risk at that cap rate" . "

Real, real, REAL rough rule of thumb (to be taken with a pound of salt, like any other investing rules of thumb): 8.5% seems to be the 'sweet spot' for many investors. Too much higher represents tougher to navigate areas. Too much lower indicates super competitive markets. That's not to say you can't make money in either of those areas, but more specialization is typically advised before tackling them. 

Good luck!

[Ryan E.]

@David Faulkner @Matt R. @Ned Carey

I really miss Bob Bowling...before he was banned I was making my way through his posts (a monumental task!) and I was learning so much about Cap Rates! 

At the very least BP should show his profile so that people like me, who go through and read the posts written by subject matter experts, can keep learning! 

[Immanuel Sibero]

@Ryan E.

Agreed... I find myself going to Biggerpockets less often these days (likely to drop down to Plus from PRO). Don't get me wrong, there are many experts on BP with deep knowledge and experience in multitude of facets in RE, but you can also find them elsewhere off or on the net. When it comes to Cap Rates though... BP was it for me (courtesy of Bob Bowling of course).

I have learned enough from Bob to have a solid grasp of Cap Rates, also enough to be amazed at how much misconceptions, misuse, and abuse of Cap Rates are still out there. Equally amazed at clueless posters further perpetuating those misconceptions, misuse, and abuse. No wonder Bob used to get cranky within a couple of posts...

[Matt R.]

Originally posted by @Immanuel Sibero:

@Ryan E.

Agreed... I find myself going to Biggerpockets less often these days (likely to drop down to Plus from PRO). Don't get me wrong, there are many experts on BP with deep knowledge and experience in multitude of facets in RE, but you can also find them elsewhere off or on the net. When it comes to Cap Rates though... BP was it for me (courtesy of Bob Bowling of course).

I have learned enough from Bob to have a solid grasp of Cap Rates, also enough to be amazed at how much misconceptions, misuse, and abuse of Cap Rates are still out there. Equally amazed at clueless posters further perpetuating those misconceptions, misuse, and abuse. No wonder Bob used to get cranky within a couple of posts...

 Agreed. He was up there. One of those few experts that forgot more about the subject than we can know. 

[Daniel P Willis]

@Llewelyn A. Thank you, that was very helpful!