How to find a cap rate

Question

In order to come out with my offer price on a 6 units multifamily building i'm looking at recent sales in the area. I also came out with what I believe is an accurate NOI. My question is simple, how do you come up with the cap rate in the area without knowing what is the actual NOI for comparable properties? I could have used the NOI I calculated for the property I'm planning on purchasing and compare that with my comps saling price but all other comparable are not really similar and have different number of mix units, larger in size etc.
          
          To me it sounds like the best way to come up with the offer price would be to realy study comps (i.e. per unit, per square/foot) and come up with what I believe is reasonable offer.
          
           Knowing the NOI of my property will only give me a feel for my expected return but will not help me determine my offer price.
          
          What am I missing here?

Don Konipol · Answer

I have to put myself in the camp of those who think relying solely on a cap rate, or any quick numerical analysis, can result in bad investment decisions.  Cap rate is, like all similar formulas, a look into the past.  What matters most is the future, if the area you're investing in deteriorates and rent are cut in half your investment may be a disaster no matter how high the cap rate; if demand for your property greatly increases and rents triple you will make money even buying at a low cap rate.

I use the cap rate as a filter for eliminating properties where I expect the property demand to remain stable.  In areas in which I expect decline i rarely find a property where the owner is willing to sell at a high enough cap rate to entice me.  In areas that look like good prospects for increasing demand I will accept a lower cap rate, however many of these properties already reflect the full anticpated demand increase.

Bill Gulley · Answer

Very good point Don. That is why I'm not an advocate of financial analysis being the deciding factor to acquire any property. You can do proformas until the cows come home, or longer and never hit on future occurances in reality! All financial ratio analysis is historical. You can develop models to convince yourself of anything you like.

The real key to locating a good investment is identifying one that is not utilized to its highest potential and, that with improvements, can be accomplished with a quick break even.
The best improvement to make with little cost is a change in management.

For me, any property that doesn't eat the hay, living on its own and that matures in value is a good deal. Eventually it will have equity and value that adds to your net worth which can translate into many different opportunities that will improve your position. Pretty simple.  Bill

Vikram C. · Answer

The first thing to remember is that the specific characteristics of your investment have to justify the price you pay for it.  Even if you buy your property for a higher CAP rate than what is prevailing in your market, it could still be a poor investment.  Looking at market CAP rates only gives you a general idea about the initial cash flow yield in your market based on what other investors have paid for their properties.  Following other investors is not a good idea, as millions of homeowners are now discovering as their homes are foreclosed.

You need to determine a few things for yourself before you can make an offer on a property:

1.  How much initial cash flow do you want from your property?

2.  What are your expectations of rent growth for your property?  Is this expectation based on what others are saying or on hard data and clear economic prospects for your area?

3.  What is the return that you would like to make you satisfied with an investment?

Your offer should depend on these things and not the market cap rate.  I do agree that it is important to know the market cap rate in order to avoid overpaying for a property but in all likelihood you will find that the market cap rate is not sufficient to meet your investment goals.

If you do wish to find the market cap rate, here are a few things you can do:

1.  Check the commercial listings in your area and similar areas to get a general idea about the cap rate there,

2.  Check a few recent sales there and assume NOI of about half of gross scheduled rents and then try to estimate the cap rate for those sales.

3.  Talk to some commercial brokers in the area and ask them for information.

Good luck and be careful with your money.

Jonathan G. · Answer

thank you all for responding!

Bill Gulley · Answer

Curtis, you might if you're seeking financing from a JV partner or HM lender.  Your assessment is only one approach to value. If you're seeking conventional financing, you won't need the GRM or the Cap Rate, since the borrowers' opinion doesn't count, it's what the appraiser says it is.

I agree, knowing the market is key, making adjustments to comps is as much an art as a science and it is only through experience that this aspect is accurately preceived. Neighborhood by neighborhood!

Curtis Gabhart · Answer

1) If you plan on getting financing you are going to need to get an idea of the market metrics like 
CAP, GRM, Price per unit, Price per square foot.

Otherwise how are you going to know how much can be financed and how much money you need?

In addition you need to find out the market rents for similar properties and expenses. The best way to do this is to 1) call the owners directly and 2) talk to brokers who specialize in those niches and sold/listed the properties you are comping out.

You should know all of this before you even go shopping for properties. If not you'll never know if a deal is good or not when it is sent to you and you'll either buy something that was a bad deal or pass up a good deal because you don't know what you are looking for.

As far as buying a property based on current numbers or market numbers are just a few pieces to the puzzle. It's all just part of the theory of proper investing and an opinion.

For example I can pay a higher than market price based on a  cap rate for a property that is under performing as long as I know I can increase my NOI and come out better than buying a property with a market CAP at a market price.

The reason you want to know the CAP rate and other metrics is you have to start with the fundamentals of analyzing investment properties and those metrics are where you start.

A lot of people say you can't look at cap, you can't you at grm, you can't you can't you can't.

Well those are general statements and are usually further down the line, but you need to start somewhere.

First you need to figure out what you are trying to accomplish when buying an income property. Start with general ideas and start filtering them down into specific measurable items.

Step 1 - Your experience level, money, credit, do you need a partner?, are you getting a loan or seller carry
back or some other creative financing mechanism.

Step 2 Based on the criteria above start with Size, location, condition, down payment, return expectations

Step 3 At this point you should have narrowed down what you are looking for (if you don't narrow down your searches you'll chase your tail or at least shoot your eye out.

Start looking at see if you can find any properties that matches your criteria. If not go back to the drawing board to see if your expectations are realistic.

I used to get people calling me all the time in San Diego looking for 8 CAP rates. Well that was a waste of time so at that point you either move to a different market, adjust your expectations or wait on the sidelines in the hope that the market will change from a 6 cap to a 8 cap.

When you have established your criteria and started looking you will THEN learn what the market is for the different metrics including rents, expenses, cap, grm etc.

Once you have learned the market when a deal comes across your desk you will know if it is a deal or not

So how do you come up with your offer price.

1) know the market. If you don't how do you expect to be able to negotiate well. If you only know what you wish for without any type of reality check you will most likely waste everyone's time. I see this with new investors all the time by thinking because carlton sheets tells them to make 50% off offers it flies. Well it may occasionally but most of the time it ruins your credibility and any chances of coming to a successful close.

Know the market by asking the questions up above and driving and surveying every property that has sold in the last 12 months, pending, active, expired and canceled.

Take notes on the properties like condition location etc. Then call the agents who sold/list the property and find out more information.

Do a rent survey in the area to find out if the rents are market or below market. Find out what the expenses should be in the area.

Now you can apply those numbers across the board to come up with true values. If for example you see something under rented and selling at a 7 x grm you can apply market rents and see what the actual grm is.

By knowing these things better than the other side you can come back to them with an educated counter based on some facts.

If you then also try to look at the negotiations from there point of view you. Why are they selling, whats important to them (not always money). How can you help them achieve that...

Put all that together and it gives you a better idea how to value the property you are buying and how to negotiate that price.

btw - if you are expecting a 15% cash on cash and the market is only 7% hopefully you figured that out way before you started putting in offer because the likely hook of you achieving that is remote.

Bill Gulley · Answer

Hi, I suggest you simply call a commercial real estate broker and tell them you are wanting to look at some properties in the area. Ask them what is commonly used as the CAP rate, pretty simply because they see it on appraisals all the time. You can also call a commercial property appriaser. Your bank can also tell you what they see on appraisals in the area.

You are correct to view comps on a sq ft basis, as exact comps are usually not available. Remember there are three approachs to value, income, cost and market. Cost is the least weighted as new costs after depreciation are less reliable. Market is the most reliable and income is based on what is expected in your area based on that cap rate.

Don't be misguided by pure BS in your analysis. Any property should be viewed on actual numbers and what your expectations are, not what other investors expect since only you know your personal situation! I suggest also you look carefully at current management and if improvements can be made.

I also suggest that if you can, get a copy or a narrative appraisal and following the outline will help you in your determinations. Good luck, Bill

Bryan Hancock · Answer

Keep in mind that the recent sale's cap rates were probably underwritten incorrectly and that those investors have a different weighting for their equity, which will distort the analysis some.

Instead of using cap rates I would look at comparable price/door as a sanity check.  See the post I referenced above.

Bryan Hancock · Answer

You are not going to find good "market cap rate" data.  See the discussion at the trailing edge of this thread:
          
          Buying An Apartment Complex

How to find a cap rate

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