With a background in a commercial real estate I’ve been around the block when it comes to investment analysis. What makes a lot of people nervous about real estate investment analysis is that it involves Math… with a capital M. That said, real estate is not rocket science but there’s no shortage of TLA’s and FLA’s in commercial real estate (three letter acronyms and four letter acronyms). Sure, it’s helpful to understand internal rates of return and cash on cash returns, but if you want a solid base, what you really need to understand is Cap Rates (Capitalization Rates). And I don’t mean just knowing the formula, but getting a real sense of what it means. It’s not glamorous, but it’s the cornerstone of understanding real estate investments, and if you understand it well, everything else will fall into place.
Simply put, a cap rate is a return on investment. A 6% cap rate means you get a 6% return on an investment. A $1,000,000 property with a 6% cap rate returns $60,000 per year (6% of $1,000,000). What does an 8% cap rate get you? $80,000 per year. Cap rate is only about income, so appreciation is not part of the equation. It represents a return just like when you put your money in your savings account and get an interest rate annually. So for example, you could put $1,000,000 in the bank and get 3% return annually ($30,000) or you could put $1,000,000 in real estate and get 6% annually ($60,000). The difference being that you have a guaranteed rate of return with a savings account and a “projected return” with a real estate investment.
The key part of cap rates is income. This is calculated by looking at rental income, and subtracting expenses to calculate how much is left over. The amount of income after expenses is referred to as Net Operating Income (NOI). NOI is the golden goose of real estate investments. The most important thing you can know about a property is the NOI. Do your own analysis and sanity checks when it comes to NOI (we can help). Real Estate Agents are people too, and most of them aren’t very good at math. In most cases NOI is income (usually rent) minus maintenance, insurance, and taxes (expenses). Note that mortgage costs are never included.
It can be helpful to look at cap rates in a couple of different ways. First, if you’re making a cash purchase you can look at returns like the example above (invest $1,000,000 in cash and get a certain return), and second, if you were able to get 100% financing it allows you to see what your actual cash returns would be. For example, if you bought a $1,000,000 property and were paying a 4% interest rate on your loan, but your cap rate was 6%, then the difference of 2% would be your profit. So a $1,000,000 loan at 4% would cost $40,000 a year, and a cap rate of 6% would produce income of $60,000 per year, so you’d be making $20,000 profit per year with zero money down. Of course real life examples are usually neither cash purchases or 100% financed purchases, but it’s a good way to help think about the returns.
So what about the actual math? A cap rate is most useful in two formulas. NOI/price or value = cap rate. and NOI/cap rate=price or value. For easy memorization, all you have to remember is that there are three key elements: NOI (Net Operating income - the golden goose), Price or value (what someone is asking or what the property is worth), and cap rate (the rate of return). Remember NOI is the most important thing, so we ALWAYS start with that, divide it by either of the other two and we get the third value.
Real life example number one: NOI/Price or value=Cap rate - if we have a property with an NOI of $80,000 and the price is $1,000,000, then we divide $80,000 by $1,000,000 and we find out the cap rate (rate of return) is 8% (0.08=8%). We generally use this formula to find out what a property should be priced at based on the amount of income it’s producing. If the cap rate is lower than expected it’s probably priced high, and if the cap rate is higher than expected it may be priced low. Remember, as an investor we’re always looking for a higher cap rate.
Real life example number two: NOI/Cap rate=Price or value – if we have a property with an NOI of $80,000 and we are looking for a cap rate of 8%, then we divide $80,000 by 8% (0.08) and we find out the value is $1,000,000 (if we’re looking for an 8% rate of return). We’d generally use this to find out what a property is worth if we’re looking for a certain rate of return. If our rate of return shows a value higher than is being asked then it may be a good buy, but if our rate of return shows a value lower than is being asked it may indicate an overpriced property.
The third formula is Price or value x Cap rate = income. (following the above example $1,000,000 x 0.08 = $80,000). While this is interesting to fully understand the dynamics between the three key data points, if you’re shopping for property you won’t usually use this one. Remember, NOI is key and you can use that to determine the value (what you’re willing to pay if you have a rate of return you’re looking for) or the cap rate (what the rate of return is).
If you’re still with me, this is what you really need to understand. If you understand the above fully you’re ahead of 90% of investors.
Here’s a few more pointers to keep in mind once you understand the dynamics of cap rates.
Certain property types, in a certain condition, in a certain location command a market cap rate. For example, a 5-10 unit multifamily property in average condition in Novato may command a 6% cap rate. If that’s a baseline for that type of property you can assess how well a property is valued based on it’s cap rate. A 7% cap rate property may be attractive, and a 5% cap rate may be unattractive. This “market cap rate” is true for any property type in any area. So if you’re shopping for warehouses in Sacramento it’s important to know what a typical cap rate is.
So why not just buy the property with the highest cap rate? In a perfect market, the baseline cap rate should reflect risk. For example, a high end multifamily property in a desirable neighborhood will likely attract renters with good credit and stable income, while a run down property in a less desirable neighborhood may attract renters with poorer credit and less stable income. The run down property will be more work to manage and will have less predictable income, so you’d expect a higher cap rate. The second element to understand is that a property has two ways of making you money – income and appreciation. Cap rates are about income, but if a property is going to double in value over the next year any investor would be happy to accept a zero cap rate. It’s OK to make no income (NOI) if your $1M property is going to be worth $2M next year. That said, be careful with speculations. Also keep in mind that’s why many out of state properties with an expected appreciation of zero might have a better cap rate than California properties that expects appreciation.
In a perfect world NOI figures would always be accurate, but NOI figures are often optimistic at best, or fraudulent at worst (which is why we need to calculate our own numbers). Many NOI numbers are based on “Pro Forma” numbers which usually reflects an optimistic representation of what the property could be worth. They often include a rosy 5% vacancy rate which isn’t realistic in most markets. Other “real” numbers may be the result of a property owner purposefully under reporting expenses. Many seasoned investors will have multiple properties and if they’re planning on selling one they’ll apply vendor expenses to another property – yes it’s fraudulent, but it happens all the time. Most investment properties (5 units plus) are not subject to the same disclosure and consumer protection laws that single family properties are. Bottom line, its investor beware – but if you do your homework you can get a good return.
Additional metrics (measurements of value) can be helpful in doing a sanity check on a property. Perhaps the simplest is the Gross Rent Multiplier (GRM). Take the price and divide it by the gross annual rents to find the GRM. For example, if the price of a property is $1.2M and the gross rents are $100,000 a year then the gross rent multiplier is 12. This can be a quick way to assess value if you’re looking at similar property types in the same area. It can also be a sanity check, if you’re looking at two properties that have similar NOI but different cap rates (because expenses are different). If the properties are similar you’d expect expenses to be similar, so if they’re not that can sometimes unearth an opportunity. For example, an owner may have had high expenses one year due to bad luck or poor management, and normalizing that might enable you to get a better return. Or another owner may have fudged the books a little and you might be able to see that when comparing to other properties. As an investor a lower GRM is more attractive (the opposite of cap rates, where a higher cap rate is more attractive).
As you might have gathered, we can dive deep into all sorts of scenarios. At the end of the day we’re here to empower you. Having a knowledgeable partner will keep you on the right path, so feel free reach out to us for more information. We primarily work with residential sales and multifamily investment properties. If you’re looking at specific types of commercial properties outside of that we may refer you to a trusted commercial broker who specializes in what you’re looking for, but we’ll stay in communication to help you evaluate any opportunities.