Cap Rates – The Great Equalizer

Episode Sumary

Today we’re talking about cap rates (and the cap rate formula), what I call the great equalizer. I say this because we make the presumption that cap rates are just that- an equalizer amongst all property types for all the deals that we’re looking at. If that’s true it means that we’re always getting net operating income (NOI) right from the beginning. If we have a good NOI then we probably can always come up with a good cap rate.

Episode Transcript

[00:00:35] But there are so many pieces to that and that's why you as the investor must have your own systematic way for delineating and concluding what the cap rate is. If you're just looking at proposals all day and there's 5, 10 or 15 on your desk and the only thing you ever looked at was the stated cap rate how do you know if all cap rates presented to you are equal? The answer is you don't. Which is why you must have a methodology in place for determining cap rates yourself as an investor (or by your investment advisers) so that you know what's coming at you when you're looking at a deal and you know that the cap rate was determined with a methodology that you believe in. That allows confidence in your investment decisions. Without it we're always in a grey area.

[00:01:33] Let's look at the definition of cap rate, or capitalization rate. This is the cap rate formula:

The capitalization rate is defined as the ratio between net operating income (NOI) to the value of the asset, or the ratio between NOI and original cost or price.

That's the most succinct definition I can provide you for what a cap rate is: NOI divided by price (or purchase price). The lower the cap rate the higher the value of the asset. The higher the cap rate the lower value of the asset, or the lower the price of the asset.

[00:02:11] We want to say “oh it's a 10 cap.”  That's a great deal. No, we already know you can't make that investment decision exclusively based on one data-point because a ten cap for a deal that’s completely eaten up with termites isn’t a ten cap because it's going to require a substantial investment in addition to the originating purchase price. Without getting into the weeds, how do we calculate a cap rate? By dividing NOI by purchase price. Example:

  • NOI of $50,000 divided by a purchase price of one million dollars equates to a 5 percent (5.0%) cap rate.
  • NOI of $670,000 divided by a purchase price of $10 million dollars is a six point seven (6.70%) cap rate.
  • NOI of $353,250 divided by a purchase price of $5 million dollars equates to cap rate of 6.04%. There's the math. That's the easy part.

[00:03:24] The question is how do you determine what is a good cap rate. Cap rates in today's marketplace can go down to two and maybe up to 10 or 12. There's everything in between. How do we determine what's a good cap rate? and all It depends on three things.

[00:03:44] One is the property type because once you define property type, whether it's warehouse, office, medical office, industrial, light industrial, residential multifamily- once you determine property type- then there's going to be a range of values or cap rates where that asset class trades.

[00:04:05] And then beyond property type, there is market. Chicago and Detroit are not the same and nor do they present the same with respect to cap rates. We can say the same thing for San Francisco versus Sacramento; although there is proximity there they're not close in terms of valuations nor in cap rate.

[00:04:27] And then the third item, with respect to what's a good cap rate, is not related to the property or the market at all but it has to do with the investor. The question for the investor is what is your hurdle rate?

[00:04:41] Every investor is going to have a certain yield that they're looking to capture and that hurdle rate will determine what cap rate the investor is are willing to accept. If your hurdle rate is 14 percent cash-on-cash long-term then you're going to have a hard time buying low cap rate deals because you'll have a hard time producing that hurdle rate of 14 percent cash-on-cash exclusively based on a cap rate of X which is low. What determines the cap rate is more than just the property and more than just the market. The investor also has to determine for themselves what is a good cap rate.

[00:05:23] For cap rate comparisons you have to have a value in mind with respect to making investments decisions. That investment decision value leads back to what you hurdle rate is. You must use what we call equal standards of comparison for assets and even that being said it still relates back to the hurdle rate of the investor with respect to what is or is not a good cap rate.

[00:05:53] Next area of discussion is variable's. There are so many variables with respect to cap rates which is why I started the episode by sharing that you the investor must have your own guidelines in terms of what you will utilize to determine capitalization rates; what goes into that calculation (which always leads back NOI.

[00:06:15] Let me give you an example of two properties in the same market. We're looking at comparable properties, Property #1 cap rate is derived adding in management fees and the new tax rate once the property transfers. Property #2 cap rate is derived excluding management fees and using the current real estate tax rate. Although we're looking at the same exact asset we're looking at two different ways that two different investor groups came to a conclusion on what the cap rate is. The cap rate comparison delivered from these two separate groups, looking at the exact same property, the cap rate delivered will be completely different. The two groups will come up with a completely different valuation even though they both said they determined the cap rate thus and such. The numbers will not match up. There is always variables and variables lead to how the calculation is determined.

[00:07:18] With respect to your calculation, you the investor, you should make sure to not lie to yourself. We don't want you in lying with statistics. Whatever calculation metric you come up with for cap rate although baseline is NOI divided by purchase price of course you realize there's more to it than just that.

[00:07:40] There can be an additional investment post-closing that you want to capitalize so even though the purchase price of the property is $5 million dollars if you recognize going in that there's another $500 thousand dollars in capital going in on day two of ownership then your real purchase price is $5.50M.

[00:07:58] We're not talking about accountancy per se, or just the paper (mortgage debt). The nuts and bolts of an initial purchase price is $5.50M so with respect to cap rate you would use that number (the $5.50M) so that you’re not fooling yourself with respect to what the cap rate actually is.

[00:08:20] On the flip side, if you're putting in that type of an investment post-closing you're likely expecting some increases in rents. So, your cap rate will have a X amount percent on closing day but then it will also have in your business plan or projected cap rate of X after the redevelopment. The numbers change (NOI projection and cap rate) once that additional investment is made. We likely have a different value to the asset if we're expecting a different rental amount and a different NOI.

[00:08:57] So the cap rate calculation isn't done just once, at the beginning of the process. And it's not something that's done exclusively once a year when the business plan is updated. It will likely be down whenever there is an additional infusion of cash.

[00:09:13] Let me give you a few examples of how people can project value from a cap rate. Let’s use 2 acres of bare land and the 2 acres and land is presumed to be in the family for the next two generations. So, we know we have two acres of land. But what we don't know is what the value of that two acres will be in 10 years, 20 years and 30 years. But what if in year one you plant two acres of walnut trees. Walnut trees take a very long time to grow. But we already know we've already made the presumption of two acres will be in their family for the next several decades. So, that two acres of walnut trees will have a zero return for the next 20 or 30 years if we're growing walnut trees. But at the end of that term when the trees are harvested then we would have a valuation of X million of dollars (based on today's prices). So, when we're looking at cap rates you also should always remember to put in the time value of money because a cap rate at closing is not the same as a cap rate or disposition or sale. The question is how much time is between those two events? That's the only way to determine yield.

[00:10:36] Cap rates has some benefits to it but an additional benefit is being able to utilize it to determine value at every point along the calendar whether that's quarterly, annually or longer yet we have to make a distinction of what the time value of money is. even with cap rates which means that we can't just presume an investment today that's sold in 40 years we'll have a great return. We don't know what will happen over the course of 40 years even if we plant walnut trees even if they grow all the way to maturity. That's so far out on the time horizon that it is hard to determine what our return on investment will be today.

[00:11:22] Another example would be what people have done in the past with date stamped certificates. Now in the United States in our history we've had these $10,000 dollar certificates that at one time had a value of $10,000 dollars. But once that was paid those certificates were cancelled but those little pieces of paper are still around and still collected. Even though they say they have a face value of 10000 dollars per back of the document says that debt was paid at ten thousand dollars in value was paid out. So just having the certificate is not the same as having the ten thousand dollars in value because it does reflect that it was already paid. So even though that certificate may be worth several hundred dollars just as a historic relic it's no longer worth ten thousand dollars.

[00:12:10] It's very unlikely that the canceled $10,000-dollar certificate will ever get back to being worth ten thousand dollars. Projecting cap rates, projecting in value, has a lot to do with time. So please always make sure to tie your cap rate to a calendar. And I think that's what I'm attempting to say in conclusion of projecting value with respect to cap rates.

[00:12:40] When reviewing cap rates always take into consideration market dynamics. Is it a buyers’ market? Is it a seller's market? What is investor sentiment? What are rental growth rates and what's the availability of financing because the availability of financing? Availability of financing has a lot to do with valuations because when money is free flowing prices tend to rise right and when money is tight and investors are required to put more cash into a deal everything becomes a little bit more conservative. You've got to sharpen your pencil just a little bit more to make the deal work. Earlier we were talking about investor hurdle rates. The more cash investors have in a deal, when availability of financing is tight, that requires them to lower their expectations with respect to real estate investments in terms of cash-on-cash yield and maybe even ROI. We must take into consideration cap rates in the moment but also over time because our return on investment is not exclusively based on what we buy and when we buy it; it's also based on how long we hold it and what we sell it for. Those (ROI) projections have a lot to do with your presumptions and acquisition.

[00:14:05] Look at cap rates not only at purchase but at least annually, if not more so. And in front of disposition or sale or when you're about to take a property to market (and about to could be a year out) Yet still you want to have your cap rate projections in order you want to have your expectations in order with market realities. at the time of sale.

[00:14:29] It may be that market realities tell you that you need to wait, or that you need to cut and run and reinvest you're collected dollars into something else versus trying to hold on to that investment assuming that it will increase and value even more over time.

[00:14:48] Brass tacks, with respect to cap rate, is used cap rates as part of an acquisitions due diligence process that you yourself have faith in. You must believe that your cap rates, the ones that you are delivering, are real and correct irrespective of what is being delivered to you for review. Your cap rates must be uniform so that the numbers you derive provide faith in the numbers for making investment decisions.

[00:15:17] Your cap rate review should at a minimum be part of your annual business plan for the asset and likely even more often if markets are changing rapidly.

[00:15:30] So that's our recap on cap rates (pun intended). I hope you enjoyed this program. Think about cap rates from the perspective of being one of many tools in your toolbox, but a very important tool. But again, you must create it, in a way that you have faith in the instrument, that you have faith in the outcome for it to have any real value to you.

[00:15:57] This has been John Wilhoit on real estate.

Here is a related article: 5 Sources of Yield from Real Estate Investing

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