Cap Rate

Now that you know how to calculate your NOI (see info below), it's time to teach you about Cap Rate. Cap Rate is the second key component you need to understand in order to calculate the value of your property.


Scheduled Gross Income

-Vacancy

+Other Income

=Effective Gross Income (EGI)

-Operating Expenses (TIMMUR)

Net Operating Income (NOI)


Here are two versions of the formula I'll be teaching you how to understand this week. The first one is NOI / Value = CR and the second one is NOI / CR = Value.

This first formula, Net Operating Income (NOI) divided by Value equals Cap Rate (CR), will show you how to find the Cap Rate for your property. First off, Cap Rate is short for Capitalization Rate. Basically, it's the return you get on your money if you bought a property using all cash. Yes, I know you probably won't buy a property using all cash, but this is how and why the Cap Rate calculation is important; it allows you to compare apples to apples. So if you found a $1,000,000 property, purchased it for all cash, and, at the end of the year after deducting all of your Operating Expenses (TIMMUR) you had $90,000 left over, you'd have a property generating a 9% return or, more commonly referred to as, a 9 Cap property. So when you hear the phrase, "It's a 9 Cap property", or "I just bought a 7.5 Cap property", they are telling you that if they paid all cash for the property, they would be getting a 9% or 7.5% return on their money, respectively. Why? Let's look at the formula.

NOI / Value = CR

$90,000 / $1,000,000 = .09 or 9% (move the decimal 2 places to the right to get the percentage)

What if this same $1,000,000 property generated only $80,000 after all of your expenses are paid? Then, you'd have an 8 Cap property. $80,000 / $1,000,000 = .08 or 8%. What if it generated $106,422? Then, you'd have a 10.6 Cap Rate property. $106,422 / $1,000,000 = .1064 or 10.6%. Again, just move the decimal 2 places to the right to get the percentage. Did you notice I dropped the '4' from the last example? Typically, you would only go to tenths of a percent when talking about Cap Rate. The only time you might go to the hundredths position is if you were at 1/4 or 3/4 of a percent such as; 9.25% or 7.75% as an example.

We now know the Cap Rate for our potential purchase. I'll use the first calculation of 9% moving forward. What do we do with this knowledge? First off, we know that by purchasing this property we should make at least a 9% rate of return without even taking leverage (getting a loan) into consideration. Can you get that rate of return from your checking account, savings account or a CD? I think not. Plus, when I show you how to use something called 'Forced Appreciation' in a future lesson, you'll be blown away with the overall returns you can make on an apartment complex or other commercial property! But I digress. I use the Cap Rate to compare my potential purchase to other similar properties in the same market. I want to know if I'm getting a good deal, a bad deal or a great deal.

At this point, I will speak with at least 3 Commercial Brokers, Property Managers and/or Financiers in the market where the property is located and I'll ask them their opinion on what they believe is the average Cap Rate for similar properties within this market. I'll teach you about locating properties and finding 'Qualified' contacts in a future lesson and how to laser focus your search, but for now, let's assume the individuals you speak with are top notch and they know the market well. The first person you speak with tells you similar properties sell in the 8%-9% Cap Rate range. The second one says they sell in the 8.5%-9.5% range. And, the last one says they sell in the 8.5%-9% range. What now? I take the lower of the first three numbers from each of my sources, in this case 8%, 8.5% and 8.5%, add them up and divide by 3 to get 8.33% and I'd round it down to just 8.3%. Then, I take the 3 highest numbers, add them up and divide by 3. The higher numbers of 9%, 9.5% and 9% respectively add up to 27.5. Then, I divide this number by 3 to get 9.16%. I round up in this case to 9.2%. So now we have a Cap Rate range of 8.3% to 9.2%. If I'm purchasing a performing property
that doesn't need a lot of work, then the Cap Rate on my subject property should fall within this range, 8.3%-9.2%. In this case, our property does fall in this range as we're coming in at 9%.

Don't get hung up at this point with second guessing yourself or the seller as to whether or not the numbers they gave you are correct and provable. That comes in Due Diligence after you are under contract. For now, just take a leap of faith for the sake of learning and understanding Cap Rate for this lesson and proceed as if the numbers they gave you are accurate. We haven't even put in an offer yet. We just want to see if we're in the same ballpark.

We know our subject property is coming in within our averages for this market, but what if the Cap Rate for this property comes in below 8.3 or above 9.2? What is that telling us? Well, if your property's Cap Rate is coming in below 8.3%, you may be over paying and if your property is coming in above 9.2% you could be getting a great deal. Why? Well, let's look at the second formula now to figure that out.

Net Operating Income (NOI) divided by Cap Rate (CR) equals Value.

Some people out there will tell you to just take the NOI and multiply it by 10 to find the property's value. This is incorrect. As you can see by the formula, the correct thing to do is to divide the NOI by the Cap Rate. I think one reason some people will tell you to just multiply the NOI by 10 is because if you divide the NOI by a 10% Cap Rate, you'll get the same answer as if you multiplied it by 10. But, that doesn't help you if your market Cap Rate is anything other than 10%. Using the numbers above and knowing our property will generate $90,000 per year after the expenses are paid and now knowing the average Cap Rate for similar properties in our market will help us figure out if we're getting a good deal, a bad deal or a great deal. We'll use our $90,000 figure in this set of calculations. Unlike the examples above where we kept the value constant at $1,000,000 and changed the amount of the NOI from $90,000 to $80,000 to $106,422, this time we are assuming that our NOI will stay constant at $90,000 no matter what we pay for the property.

Therefore, let's double check our first calculation of $90,000 divided by our first Cap Rate of 9% to see if we still have a $1,000,000 property. $90,000 / 9% or .09 = $1,000,000. Yep, sure enough, it worked! Now, let's see how using the low and high averages of the Market Cap Rates affects the value. I'll use the same $90,000, but this time I'll divide it by the lower Market Cap of 8.3%. $90,000 / 8.3% or .083 = $1,084,337. Now, I'll take the higher Cap Rate and do the same thing: $90,000 / 9.2% or .092 = $978,261. We end up with a range of value for this type of property in this market from $978,261 to $1,084,337. Since our property is on the market for $1,000,000, we're coming in at what appears to be a fair price for this property subject to our Due Diligence.

Did you also notice that the higher the Cap Rate, the lower the value? Conversely, the lower the Cap Rate the higher the value? Cap Rate affects the value of a property opposite of what most people think. Most people think the higher the Cap Rate the higher the purchase price, but that thinking is incorrect and now you know better.

Back to my original question from a few paragraphs above; what if your property Cap Rate comes in below 8.3% or above 9.2%? Since a lower Cap Rate means a higher value, then if you buy the property based on a Cap Rate under 8.3%, then you may be over paying for your property compared to the average Cap Rate in that market. If you pay at a Cap Rate above 9.2%, then you're paying less than the average in that market and could have an incredible deal! Here's why:

$90,000 / 8% or .08 = $1,125,000 $90,000 / 10% or .10 = $900,000

What price would you rather pay? It's the same property generating the same $90,000 in cash flow. Would you rather buy it at a lower Cap Rate and pay more or buy it at a higher Cap Rate and pay less? I thought you'd say the later!

The last thing I want to teach you about Cap Rate is a 'Rule of Thumb' I use when I am getting a loan on a property. As a very quick reference, I want to make sure that my Cap Rate is at least 2% higher than my interest rate. That means I have to speak to a loan broker or two (or 3) to determine what my options are for loan terms. If my lender tells me current interest rates for these types of properties in this specific market are coming in at 6.5%, then that tells me I should only be looking at properties that have a Cap Rate of 8.5% and higher. If current interest rates are at 5.25%, then I should be looking only at properties with a Cap Rate of 7.25% and higher. Why? Because of something called 'Positive Leverage'. I will teach you about this in one of my lessons on Financing, along with another term called 'Loan Constant'. But, for now, just remember to make sure you do your best to only look for properties where your Cap Rate is 2% higher than current loan interest rates.

Until next week!!