“WHAT THE HECK…” is an ongoing series within The Pay Me Plan Blog for Investing Novices where I dissect a financial concept or principle, and explain how it can apply to your investing activities. In this post, we’ll be covering cap rates.
A couple weeks ago, I was speaking with the Vice President of Acquisitions at a large, publicly traded real estate company with a national presence. He’s a tenured employee with a respected track record in the industry, and he’s played a key role in some massive transactions over the years. We were engrossed in a discussion regarding some of his recent acquisition activity in various parts of the country.
When the New York metropolitan market came up, he groaned and lamented over how difficult it was to find “good product” in Manhattan. “Because the prices are so inflated due to the demand, cap rates are perpetually hovering at undesirable levels,” he said.
Capitalization rate (aka “cap rate”) is a term used in the real estate industry to assess the income return that a property will generate. Cap rates are calculated by taking the property’s annual net operating income (NOI) and dividing it into the purchase price. The net operating income is what remains after all operating expenses are subtracted from the rental income. Keep in mind that NOI is calculated before any financing costs (i.e., a mortgage) are considered.
For example, a property that generates $7,000 in annual NOI (net operating income) and is purchased for $96,000 yields a cap rate of 7.3% ($7,000 / $96,000 = 7.3%). Where this gets a little tricky is that different people arrive at NOI using slightly different calculations. Some factor in a vacancy allowance, while others don’t. Some factor in a maintenance budget, while others don’t.
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You can even use a little creativity and modify the equation to help you arrive at a reasonable asking price for the property. For example, using the numbers above, if your market research has shown that cap rates in the area for your target property type are around 7.3% and you know that your target property generates $7,000 in NOI, you can simply divide the NOI by the cap rate and you arrive at roughly $96,000 for your price ($7,000 / 7.3% = $96,000).
Generally speaking, cap rates are most often used in larger commercial real estate transactions, but the concept can also apply to smaller residential deals as well.
CAP RATES VARY BY MARKET
The rule of thumb is the higher the cap rate, the better. Because cap rates are a function of price, markets with inflated property values (e.g., San Francisco, Boston, New York, etc.) usually boast low cap rates. In contrast, markets with more reasonable property values such as areas in the South and the Midwest usually offer higher cap rates.
I subscribe to numerous real estate brokerage newsletters and receive quite a few email solicitations from different agencies. Last weekend I received an email alert about a commercial property that became available in Lomita, California. It was a mid-sized commercial building on a corner lot with a major bank as the tenant. The cap rate? An atrocious 4.4%. That’s pretty terrible by my standards. After running the numbers, the cost worked out to be over $300 per square foot. That’s a hefty price tag.
For illustrative and comparative purposes, I’ll tell you about a couple recent acquisitions for my personal Pay Me Plan. I paid around $25 – $30 per square foot for the properties, and they offer a cap rate of over 11%, and that’s after factoring in vacancies, management fees, and a maintenance budget.
The difference is in the approach. I invest for high levels of investment income, I invest in markets with reasonable valuations, and I only acquire select properties that are selling at a discount to their true value. Following this simple philosophy is what has allowed many investors to identify properties that yield high cap rates even when large commercial acquirers are settling for anemic returns.
BIG MONEY IS CURRENTLY PUSHING CAP RATES LOWER
Over the last 24 months, hedge funds and private equity companies that are moving their capital into housing markets like Atlanta and Phoenix have been overpaying for properties left and right. They’re hoping to capitalize on a rebound in home prices (read: asset appreciation, not investment income).
Because they’re not trying to maximize the cash flow provided by these properties, they’re paying absurd premiums and driving down their own cap rates. In my opinion, that’s not a prudent investing approach. Yes, they’re inflating home prices for the surrounding area, which is great for local homeowners, but it’s simply a poor use of investment capital to pay $1.35 for something that really costs $1.00.
In closing, cap rates are a useful metric to use when you’re calculating the income return provided by an investment property. Moreover, you can also use cap rates to help assess the valuation of a property. And as an important reminder, if you’re going to use someone else’s estimation of a property’s cap rate, be sure you check their math and verify what rates and expenses were used to calculate the figure.
Those are my thoughts. Feel free to share some of yours below. Thanks for reading and as always, make it a great day.
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