Many real estate investors determine the value of an income property by using the capitalization rate, aka cap rate. It is probably the one most misused concept in real estate investing.
While brokers, sellers, and lenders are fond of quoting deals based on the cap rate, the way it is typically used, they really shortcut the true use of a valuable tool. A broker prices a property by taking the Net Operating Income (NOI), dividing it by the sales price, and voila!--there's the cap rate.
Say the property has an NOI of $125,000, and the price is $1,125,000.
$125,000/ $1,125,000 = 11.1% 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.
Jul 11, 2013