Real Estate Investor Financing 101 Series: Cap Rate

[Robin Simon]

from a twitter thread:

The cap rate serves to price the risk of the NOI the asset is producing and producing a value accordingly. Cap Rates are determined for a specific property through looking at similar properties' cap rates on recent sales (comps)

Cap (Capitalization) Rate is one of the most important concepts to understand in real estate investing BUT make sure you understand its applicability to the asset class - not always relevant, especially with SFRs

Cap Rate is a fairly straightfoward metric used to determine value of a real estate asset through the "Income Capitalization Approach" to determining value. Also is effective the "yield"

Formula: Net Operating Income (NOI) / Value = Cap Rate
Alternatively: NOI / Cap Rate = Value

Example
$100,000 NOI
$1,000,000 Value
Cap Rate = 10% ($100,000 / $1,000,000)
This million dollar property has a cap rate or "yields" 10% annual returns in the form of a $100,000 net operating income. Similar to a $1M bond that yields 10% interest

Generally, cap rate refers to how "expensive" your real estate cash flows are, the lower the cap rate, the LESS risky the cash flows are. This is because every real estate asset kicking off $100k NOI is not equal and worth the same thing.

For example - would buy a Class A multifamily yielding $100k annual NOI in a tier one city or a aging strip center in a declining market also yielding $100k annual NOI? Which NOI is safer long-term? Which property will likely appreciate vs. lose value?

You'd be crazy to value these properties the same even though they produce the same $100k NOI

This is where cap rates come into play:

The multifamily may have a 3% cap & be valued at 100k/3% = $3,333,333 while the strip center may have a 12% cap & be valued at 100k/12% = $833,333

Cap Rate is so important here because the market (buyers) are the ultimate arbiter of value in real estate and the buyers of commercial and multifamily buyers are INVESTORS always and primarily looking to buy for cash flow and ROI potential. A very important wrinkle for SFRs (single family residences) is that buyers are primarily NOT investors, but homebuyers (stark distinction with commercial and multifamily). Thus how the market values SFRs is DIFFERENT since most buyers aren't strictly looking at cash flow/ROI.
MOST SFR buyers will buy for other reasons than if the property will "cash flow" - if you are a family buying a home - do you care about lifestyle, space for the family, your commute etc. or what it would theoretically rent out at? Buyers are focused on other things.
Thus while Cap Rate (yield) is the overwhelming driving factor of valuation on commercial/multifamily properties its not as applicable or important for SFRs EVEN IF YOU ARE BUYING AS AN INVESTMENT (because the market, not you, determine the value).  Therefore, 
for SFRs, the overwhelming driver of value is sales comps rather than income capitalization. The Cap Rate can be a relevant factor in your investment decision, but important to remember its not really the right valuation tool for this asset class.