Qs about Cap Rates, Appreciation, and at sale calculations

[Fran Arti]

Hi, guys:

I have several questions that I dont get right at the moment. Im doing a bunch of projections and calculations with a variety of scenarios to get confident enough to buy my first deal. With this my questions are:

- When it comes to calculate the exit cap rate of a property, how is it calculated? Heard that brokers can give you and estimate and heard (Justin Kivel, Breaking into CRE - Youtube Channel) that the industry standart is to add +0,1% cap rate during your holding period) and Im confused. How I can know the cap average in my area for my type of asset/class?

- Then, in terms of appreciation vs cap rates, in my deal analysis simulator, I must fill an average % of appreciation per year. If I bought at 1M, the asset will appreciate 5% a year during 4 years, then the final value, appreciated is 1.215M but I think I have to take into consideration factors like NOI, cash flow after taxes, the "calculated" cap rate at resale, economic occupancy, % vacancy, etc, to have the big picture and look at it with a next buyers eye.

Thanks for your time, have a great sunday a week ahead.

[Immanuel Sibero]

@Fran Arti

Forget the video, it is misleading when people (even very experienced investors) say a value add project is when you purchase a property, increase the cap rate, and then sell it for a profit. I wish they would stop saying that because it confuses a lot of people trying to understand cap rate. A classic value add project is when you purchase a property, increase the NOI, and then sell it for a profit. So your effort to add value is by doing something to NOI not doing something to cap rate. So what do you do with NOI? You increase it! How do you increase it? You increase revenue, OR decrease expenses, OR both, that's it!! So what do you with cap rate??? Well... Nothing! Who cares!

When I hear people say "cap rate", I pay attention to which cap rate they are referring to. Many investors (even syndicators) may not even realize which cap rate they're talking about. There is the "property" cap rate, then there is the "market" cap rate! The property cap rate is the one that many investors calculate every year by taking the NOI of their property and divide that by the original purchase price of the property (pretty useless, IMO). On the other hand the market cap rate is a measure of how much investors in a particular market are willing to pay for a particular type of property at a given time. Sometimes, you hear this market cap rate referred to as "market sentiment". It's a measure of how desirable/appealing the properties are to the investors in that particular market (think California).

If you refer to the chart above, I listed two kinds of cap rate (propCap Rate and mktCap Rate). propCap Rate is simply NOI/Purchase Price. mktCap Rate is, again, a measure of market sentiment and can only be obtained by talking to the local market experts (i.e. commercial bankers/brokers, property managers, etc). The point here is you don't calculate this cap rate! It is market driven and you have NO control over it. In the chart above, I'm assuming the "market" cap rate to stay the same at 5%.

So let's say you buy the property with $100,000 NOI in year one. You would have to pay $2M because NOI is $100,000 and market cap rate is 5%, in other words properties are trading at 5CAP (we will assume market cap rate stays at 5CAP). Let's say you're a syndicator with a bag full of tricks and are able to increase NOI to $150,000 in year 2 (wouldn't that be nice!). Well in year two you calculate your property cap rate to be $150,000/2,000,000 which equals to 7.5%. But remember the "market" cap rate has its own movements! It could stay the same at 5% (which I'm assuming here) or it could go higher or lower... again this depends on the market (i.e. market sentiment). In this example, if you were to sell the property, then you would likely sell it by taking your NOI divide it by the "market" cap rate - $150,000/5% = $3,000,000.

The above example is a classic example of value add! Now you could say I have increased my cap rate (i.e. propCap Rate) from 5.0% to 7.5% but it's highly misleading because people may be thinking "market" cap rate which in this example stays the same at 5% (5CAP). What I have really done is increasing my NOI, in fact I really don't care that much about my property cap rate (propCap Rate). I could take off that propCap Rate line in the chart above and everything would still make sense. Hope this helps.

Cheers... Immanuel