Commercial Real Estate Q&A #2: What in the World is a CAP Rate? #

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The Real Wealth Expert Panel

Greetings from the commercial real estate capital of the world….Cedar Crest, NM (yes…I am being facetious).

We enjoyed the snow while it lasted. With sleds and snow shoes in hand….we watched the snow come….then go. There is still snow on the ground…but only enough to be a hassle.

Anyway….today’s questions comes from Paul out in Lubbock, TX. Paul wants to understand what a cap rate is.

I remember when I first ventured into commercial real estate, I heard the term “cap rate” all the time but never understood what it meant and I was not sure why so much emphasis was place on the “cap rate.” Well….I let me friend Emily Cressey give a great response to the overrated term:

rob ….. initial review of some available Lubbock multifamily buy opportunities have cap rates all over the board. Some as low as 3% and some as high as 12% – 14%

What’s the definition/ analysis behind cap rates? From a buyers viewpoint, what am I looking for ….. a high or low cap rate? Is a cap rate a cash flow indicator? Thanks …. Paul

Emily Cressy Real Estate Investor and Coach

Emily’s Take:

Hi Paul,

Let’s start with a simple definition. “Cap rate” means “Capitalization Rate” – it is actually a percentage rate of return that you would get from the INCOME of the property if you were to buy it ALL CASH with no leverage.

Here’s the formula: Cap Rate = NOI/Price

For example, if you bought a million dollar building with no loan and the NOI was $80,000 a year, that building would be an “8-cap” (Cap Rate = $80,000 / $1 Million = 8%)

If the same building had an NOI of $90,000, it would have a 9-cap as its capitalization rate.

Understanding the formula behind the terminology makes things a lot easier to understand.

You can see that the higher the cap rate, the higher the income produced by the property, relative to its price.

Now let’s dig a little deeper.

In many markets and across different sectors, you will see a variety of cap rates. For example, here in Seattle, WA we see apartment buildings selling for 4-5 caps in some of the best neighborhoods. Buildings sold for even less than that, in the 3-cap range, a couple of years ago when developers were snapping them up to do condo conversions.

When you are looking at properties to buy, it’s helpful to know what cap

rates are normally seen in your area. Some areas, like the Midwest, for example, normally sell properties at higher appreciation rates – why? because investors don’t expect to get much appreciation there, so they demand more cash flow in order to consider the property a good investment for their portfolio.

Here in Seattle, and other areas on the coasts and other “hot” markets – we typically see a lot of appreciation. We are in very strong and stable markets. Investors see less risk and more appreciation potential, so they are willing to pay more to buy property here. It’s a tough row to hoe, though. (That rhymes!) In order to buy an apartment building in Seattle, you generally have to put 40-50% down in order to get it to cash flow. That reduces your leverage quite a bit.

That’s one of the reasons I have chosen to invest with Grasslands in markets OTHER THAN where I live – we invest in cities where we can expect more cash flow.

Another reason you might see high cap rates is because of higher risk associated with a property. Generally older buildings,

Emily Cressey

buildings in worse parts of town, and harder-to-mange properties like mobile home parks will all be offered with higher-than-average cap rates. Investors need to be incentivized with a higher cash flow potential in order to entice them into buying this type of property which may demand more work to keep running well.

The third point I want to make is that cash flow and cap rates are only one piece of the puzzle. If you buy STRICTLY based on cap rate, you will inevitably overlook some opportunities, such as properties that have lower-than-market rents, high vacancies, need repair, or are otherwise being operated at a sub-optimal level and may represent some upside potential if you can go in and help turn things around.

My friend Peter Conti has worked on a number of deals like this – apartments with high vacancy levels (say 50% vacant or more) in need of repair. He has worked with partners to acquire and run these properties, and has been able to increase the value by millions within just a few years.

This type of project can be exciting, but it requires a lot of hands-on work. If this type of property is your cup of tea, you won’t find it if you sort by high-cap-rate properties only.

When you’re looking at properties, there are about 5 ways to evaluate the property, and cap rate is only one.

Here are the five quick/easy ways to evaluate a property’s value:

1) GRM – Gross Rent Multiplier

2) Cap Rate

3) Cost per square foot

4) Cost per unit

5) Cash-on-Cash Return

We’ll save a discussion of the others for a future article, but I hope you now have a good understanding of what cap rates are, how they are used, and when they can fall short.

Keep up the good work in pursuing your investments!

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Until next time…..rob

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