Sophisticated Investor 101: What is a Cap Rate & Why Most Get it Wrong

Welcome to the first of a series of articles to help demystify the many terms and numbers used in real estate investing. The goal of this series is not only to help define terms, but also identify how to properly use the concepts to evaluate and close deals.

FIRST, WHAT IS A SOPHISTICATED INVESTOR?

You’ve probably seen the terms Sophisticated and Accredited Investor mentioned in the RE investing world and in communications as pre-qualifiers for investing in syndication deals. These are terms and conditions that are applied to many types of non-registered investments by the SEC. More info on that here.

Such investments are generally not institutionally backed or insured and may be perceived to be a higher level of risk than the common investment options offered by employers, brokers or financial advisors.

The labels and regs are mostly intended to protect you from you. This means that the powers-that-be don’t believe the average person should invest his or her money in anything but those deemed suitable by the government. These types of investments are reserved for those already wealthy or making hundreds of thousands of dollars a year.

I’m here to tell you that anyone can qualify as a Sophisticated Investor, as long as certain work is put in to meet qualifications.

While an Accredited Investor has a very clear definition, a Sophisticated Investor is defined much more broadly.

“All non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”

So, while this blog post won’t turn you into Warren Buffett, it will at least introduce some skills required to be a more “Sophisticated Investor.”

CAP RATE DEFINED

One of the most common questions I get when discussing real estate investing is how I evaluate properties to determine the investment potential. While there are many factors that come into play, the one criteria that is critical to get right in the evaluation is the capitalization rate, or cap (CAP) rate for short.

The easiest way to understand cap rate is the expected return (as a percent) an investment will generate based on the net operating income (NOI) of the asset.

CAP rate is applied against the market value of the property to determine NOI. For example, a property worth $1 million and being sold at a cap rate of 10 would be expected to generate annual NOI of $100k.

$1,000,000 x .10 = $100,000

Mind you that you are not going to find a property with that kind of cap rate these days; this illustration is simply for easier math. Also, cap rate does not include debt service. If you are financing the acquisition, that gets factored in later.

First, let’s talk about some expectations when it comes to cap rates and how to determine what cap rate to use and when.

WHAT CAP RATE TO USE

Some variables that come into play include the regional location of the property (Philly, NY, Chicago, LA, etc.), the class of property (class A, B, C or D), type of property (multifamily, office, retail, industrial, etc.), market conditions (supply, demand, interest rates), and geographic location (city, suburbs). We rely on a combination of industry research, our local market evaluation and deal marketing and transactions.

Below is a table of some cap rate expectations based on the current market for multifamily properties:

The simplest way to define different Class properties (A-B-C) is:

• Class A – brand new construction and/or prime location.
• Class B – buildings that are no longer new, in need of light renovation (facade, landscaping, common area upgrades) but overall in well-maintained functional condition and good location.
• Class C – older buildings in need of functional and/or infrastructure improvements, with a less ideal location.

Value-add properties are those in some form of disrepair, outdated or generally mismanaged. More on that in another post.

You can see a big difference in return expectations between the Philly market and coastal cities, and also between the class of properties. This is why so many investors in these areas are looking to other markets for larger returns.

The numbers I use are expectations based on TRUE cap rates. We’ll talk about how so many deals are misrepresented.

HOW TO USE THE CAP RATE

Now let’s look at some of the ways to use cap rate to determine value when buying and selling. From there we’ll get into factors that determine the appropriate cap rate to use, and then discuss some of the tricks used by brokers and agents to hide the true cap rate.

The general rule of thumb is that you want to buy at a higher cap rate and sell at a lower rate. You’ll see why in a minute.

Suppose you want to invest in the Philly area and are interested in long-term equity appreciation, but with some positive cash flow. We’ll assume that you have $100k to invest and will use financing to acquire a property for around $400k. 25% down payment is standard on investment real estate.

Let’s look at what kind of net income you can expect between a Class A and C property. Again, we are not including paying the loan here.

Class A – $400k x .055 (5.5 CR) = $22,000

Class C – $400k x .0675 (6.75 CR) = $27,000

Now let’s look at it the other way. Suppose you wanted to buy an investment property that can generate $50k a year in net income. To get the answer on what you can expect to pay we divide the number by the cap rate. Using the same examples we get the following:

Class A – $50k / .055 = $909,090

Class C – $50k / .0675 = $740,740

Another way to use a cap rate is in figuring out how much value you can increase a property by through increased rents or reducing expenses. Both will result in an increased NOI.

Suppose the property you are evaluating above has the potential to generate another $5k a year through increased rents or reduced expenses. We’ll talk about how this can be achieved in another article. Again using the same example:

Class A – $55k / .055 = $1,000,000

Class B – $55k / .0675 = $814,814

This is what we call value-add, meaning that there is potential to increase the value in a property. This may be short term if there are minor changes to be made, or longer term if it will take some time to implement.

In the above examples you can really start to see the power of using the cap rate in the analysis. You bought a property for just over $900k, increased the NOI by $5k/yr and have now increased the value to $1m!

The reason this happens is simple. The market dictates the cap rate and the cap rate is based on the NOI. In this case the cap rate at purchase and sale remained the same, but the NOI was raised by 10%.

There is a way to re-position the property by moving it from one class to another through upgrades and improvements, but that’s for another article. This would result in changing the value by using a lower cap rate.

One thing to make clear though is that in general a cap rate is mostly applied to commercial properties, which in the view of lenders are properties that are either zoned commercial or residential with more that 4 units. This is very important because if you are financing a deal then it has to appraise. Properties with 4 units or less are appraised first based on comparable sales, and then income.

WHERE SO MANY INVESTORS GO WRONG

Even though it should be easy to determine the value by using a cap rate, many new investors don’t dig deep enough into the numbers to uncover the true value.

This is often because a seller and his or her agent/broker don’t give the full picture of the performance of a property. That is to say they either don’t include all of the expenses, base the projected rents off pie-in-the-sky numbers, or a combination of both.

The first red flag is when the term Pro-Forma is used as a basis of the stated cap rate. This means that the rents and expenses are projection-based and in most cases way off!

There are cases where it’s the only way to value a property, like for new construction, and many good brokers that are honest with their numbers, but it requires much more due diligence to validate. I’ll save pro-forma for another article in this series.

Let’s look at an example. Say you are looking at 10 unit property that is being sold for $1 million at a 6% cap rate. The net income should be $60k a year ($1,000,000 x .06 = $60,000). The offering docs state that the pro-forma rents are $900 a month per unit. That means $9k a month and $108k a year. So far so good. The pro-forma expenses total $48k, which gets us to the $60k NOI.

Now let’s say this property actually is generating an average of $800 a month in rent and the expenses are 45% of the income. This brings us to $750 per unit x 10 units = $7.5k per month and $90k per year. Subtract 45% in expenses and you get $49,500.

At the same cap rate the property is actually worth $825k ($49,500 / .06 = $825,000). You, my friend, just overpaid by $175k!

How this happens is when the offer gets based off projected numbers provided by seller and the buyer doesn’t have the know-how or experience to perform proper due diligence. I see this each and every day!

Here is the minimum list of expenses you should either expect to see in an offering and dive in real deep to validate in your analysis:

1. Property taxes – normally accurate because they are public record
2. Insurance
3. Utilities paid by owner
4. Maintenance and repairs (1-3% of value per year, depending on class)
5. Landscaping & Snow removal
6. Municipal licensing
7. Property Management (5-7% of gross rents)
8. Vacancy (5%)
9. Variable expenses

If you get these right then you will be much closer to actual costs. Still this is heavily dependent on the complete and accurate records of the owner/manager of the property.

SCENARIO: LET’S RUN SOME NUMBERS!

Let’s look at an actual listing that came into my inbox recently.

First the description:

“Fully-leased quadplex in the booming Brewerytown submarket of Philadelphia, Pennsylvania on its main commercial corridor, Girard Ave. This dramatic corner property features four (4) units fully-leased/occupied generating strong positive cash flow from day one. A savvy investor could cosmetically enhance units 2/3/4 with subtle improvements to drive increased rents and boost the performance of the building in no time. These units lease quickly and are in high demand…”

Here are the numbers pulled directly from the listing. Asking price is $764,999 at a 7.5 cap rate, wonderful! The total rent claim is $65,400, with a net income of $57,524, wow! Could it really be operating at a 12% expense ratio?

No way in hell! These numbers come from the agent and seller only including obvious expenses like property taxes and insurance.

What I can tell you is that even brand new construction will operate at 30-35% expense ratio, and that’s just in the first couple of years. The rule of thumb is to assume that expenses are 40-50% of income. This would become clear as a full and detailed analysis would be done during underwriting.

If we now factor in a conservative expense number like 35%, we get NOI of $42,510. With a sale price of $765k we are now looking at a real cap rate of 5.5 (NOI / asking price). Going back to our cap rate expectations, and what we know of its location, we can cross this one off the list of properties to pursue.

The crazy thing about this deal is that because it is 4 units it will be appraised based on sale comps. The market for these types of properties has been out of control, so it would most likely appraise for the sale price. The buyer will only learn that he or she overpaid in 3-5 years.

All of the above is what I call paper napkin analysis, which is only useful for a first level filter when looking at properties. We use sophisticated tools to include all expense categories and numbers that are based on detailed analysis and years of experience, but only after a property passes a sniff test. Unfortunately, a hot real estate market drives many realty TV watchers and folks with more money than sense to overpay.

IN SUMMARY

There are many other ways to use to use the cap rate in evaluating properties, so I would suggest going on Zillow or LoopNet and finding a few investment properties to test the math. It becomes much easier the more you analyze, and you will eventually be able to quickly determine which deals are worth looking into.

It’s also worth noting that the bigger the deal and higher the class of the property, the more likely you will get actual reports of income and expenses. Larger and higher class projects are more likely to be professionally managed, with all aspects of the asset performance tracked and reported by the management company out to the owner. This helps to get a more accurate cap rate to gauge.

If you only get a one page spreadsheet, or just an offering document from the broker then you will most likely not be able to get a good picture of the financial performance of the property. This is where a savvy investor will tap into resources with hands-on experience in the immediate market and comparable asset classes to help develop a framework of realistic numbers.

Learning how a cap rate is calculated will help you go a long way in valuating investment grade properties. It is even more important to be thorough in your analysis and realize that it’s just one tool to master. Here are the formulas we discussed to practice with:

NOI / Cap Rate = Property Value

Property Value x Cap Rate = NOI

NOI / Property Value = Cap Rate

Please share your thoughts and let me know what terms or topics you’d like me to cover next.

Happy investing!