As an FHA MAP Lender, I often deal with a lot of first time buyers of commercial real estate and other people who are relatively new to the business. I appreciate the opportunity to work with such capitalists and enjoy sharing some of the things I have learned over the years.
Even with experienced owners, making a lot of money, the purpose, definition and application of cap rates to commercial real estate are not entirely understood. Further, most people don’t know how to calculate a Cap Rate correctly anyway. So let’s talk Cap Rates.
A Capitalization Rate is the rate of return one can expect based on a particular net operating income in relation to the purchase price or perceived value.
Looking at it as an equation, one would get this:
Let’s take an example: Say you have a property with $100,000 in net operating income. “Net” in this example is rental income and ancillary income less vacancy, skips and after expenses for marketing, management, general administration, utilities, payroll and related, insurance, repairs and maintenance, taxes and reserves.
In this example, if the purchase price is $900,000, the Cap Rate is right at 11%. If the purchase price is $1,100,000, the Cap Rate is right at 9%. At a cool Million, the Cap Rate is 10%.
Think of it this way: If one buys at $900,000, and assuming no debt, how long will it take to get the purchase price repaid from the property’s operations? At 9 years, the rate of return is 11.11%, say 11%. At $1,100,000, it is 11 years, or 9.11%, or just a 9% Cap Rate.
Why is this important? Well, as a buyer, the higher the cap rate, the lower the price, and likely, the better the deal. The opposite is true for the seller. In a market where sales are around, say 6%, being able to increase your net operating income can make a big difference.
Take the example of a lawn mowing service charging $500 a month to keep the grounds. That $6,000 expense to your income at a 6% Cap Rate has a multiple effect at 16.6 times against the value of the property. The lawn mowing service impacts the value of the property by $100,000. Ouch.
Say you can raise rents $5 per month on 50 units. That is $250 per month, $3,000 per year. At a 5% Cap Rate, you have improved the value of those units by $60,000, or 20 times the annual increase to NOI. Not bad.
Finally, Cap Rates are more than math. They are a method of communication between real estate people. A buyer says he will buy on an 8% Cap. A Seller responds he will go 6.5%. In our $100.000 NOI example, the buyer just said he is a buyer at $1,250,000. The seller said he’s a seller at around $1,540,000.
How do you get fluent in such conversations? Well, 8% goes into one (1) 12.5 times. Multiplying $100,000 by 12.5 gives you a $1,250,000 price. 6.5% goes into one (1) between 15 and 16 times, a little closer to 15. Okay, $15.38 times to be exact. Multiplying by $100,000, you get close to $1,540,000. Practice this and you will get good at it.
Almost Weekly, I have discussions on why lenders use a higher cap than sales, in many instances. The answer is easy: the market might be a 6% Cap on sales, but a 6.75% Cap makes a lender feel more comfortable that their loan is secure. In the case of an FHA loan, FHA does not want to be on the cutting edge of the market today, preferring to be a little from the edge, when one is talking a 35 year term and amortization.
Everyone has a comfort zone with their exposure in real estate and a capitalization rate is a great way to measure that comfort.