Why CAP Rates will make you question Everything!!!!

The Capitaliztion Rate, often called the CAP Rate, is the ratio of Net Operating Income (NOI) to the property asset value.  For example, if a property was listed for $1,000,000 and generated an NOI of $100,000 then the CAP Rate would be $1,000,000/$100,000, or 10% resulting in what is affectionately called the Cap Rate.

But what does that number tell you? Does it tell you what your return will be if you use financing? No. Does it take into account the different finance terms available to different investors? No. Then just what does it show?

What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, usually by trial and error, to find the cash on cash return on our actual investment using leverage (debt).

Then we calculate the debt service, subtract it from the NOI, and calculate our return. If the debt terms, loan-to-value, or our return requirement change, then the whole calculation must be performed again. That's not exactly an efficient use of time or knowledge.

Brokers are fond of quoting a "market cap rate." This is an effort to legitimize an assumption, but it is flawed in its source. As a comparison tool it is almost impossible by any means to find out what other properties have sold for on the basis of the capitalization rate.

In order to correctly calculate a cap rate, and get an apples to apples comparison, you must know the correct income and expenses for the property, and that the calculations of each were done in the same way explained below.

This information is not part of any public record. The only way to access the information would be to contact a principal in the deal, and that just isn't done because the information is confidential.

A broker may have the details of several deals in the marketplace, and if there is enough information about enough deals, the information may rise to the level of a market cap rate. But few brokers are involved in enough deals in one market to have that much information.

So the conventional wisdom becomes a range of cap rates for property types, which may or may not apply to the property you are looking at, and certainly does not take into account your own return requirements. So what do you do when you've found a property that looks promising, and the broker tells you the cap rate is 11.1% and you better act fast? How do you know if it is worth pursuing?

For years, I immediately jumped in the car to take a look, and then started crunching numbers making assumption after assumption to arrive at some estimated value. The truth is I was guessing. I wasn't looking at the right numbers. There is a better way. It is not a magic bullet, but it is a powerful tool to use in gauging value.

What's it worth to you?

The real question is not how much I (or another investor, or even an appraiser) value a property at. Nor is it the value from a cap rate estimated in the market. It's the value at which YOU can attain YOUR investment goals, that is reflective of YOUR borrowing power, and gives you an intelligent starting point for the analysis.

I promise you if you learn how to do this, it will give you a leg up on 90% of the brokers and investors out there. Critical to this calculation is that the NOI is figured consistently with industry norms. The generally accepted definition of NOI is:

Gross Income - Operating Expenses = NOI

Please note that the operating expenses do not include debt service, depreciation or the interest component of debt service. Obviously, the income and expenses must be verified, or all calculations that flow from them will be flawed. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can settle the income stream conclusively.

On the expense side, normal due diligence includes verifying with third party suppliers as many of the expenses as possible. But take care evaluating the operating expenses to uncover any anomalies that exist under the present ownership.

Owners often take a management fee that may or may not be market based; maintenance expenses may or may not include labor charges; items such as "office expense," "professional fees," or "auto expense" (I love that one myself!) may or may not be property specific.

In short, before accepting the NOI presented, understand what is behind the numbers. This is known as "normalizing" the numbers. You can also tweak the numbers to reflect the way you will own and manage the property.

No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOIs, and two widely divergent values, and both are right. 

Non of this is original thinking, it is an accumulation of many transactions and articles and just good old "common sense".

Next post will cover my C-S-L-M Formula.  In the meantime, please post your comments or contact me to discuss any topic.