What is the CAP Rate or Capitalization Rate? (Creating Gold Part II)

In our previous blog post, “Creating Gold with Commercial Real Estate” I explained that we liked multi-family properties like Apartment Complexes, Mobile Home Parks, and Self-Storage Facilities because there are many ways to drive the value of the property higher by driving the Net Operating Income (NOI) higher.

NOI is defined as Gross Actual Revenue (the amount of money coming in) minus normal operating expenses.  Normal operating expenses for the purposes of calculating NOI do not include things like principle and interest loan payments, capital expenditures, depreciation, income taxes, and amortization of loan points.

To fully understand how you drive the value higher you must also understand the importance of the CAP or Capitalization Rate.  The best definition I have ever heard of CAP rate is “if you bought a property for all cash and your NOI = 7% of the cash price then your CAP rate would be 7%.  I also like to think of it as what is my return on the total amount paid for the property, including the down payment and closing costs. CAP rate is expressed as a %.

Some people try to buy Commercial Real Estate (CRE) at a certain CAP rate to determine if the deal is good for them.  For instance, we like to buy property at a 10% CAP rate or higher.  But it is also important to understand that certain classes and location of CRE will also drive what the CAP rate will be for that property.  For instance Apartment Complexes in the Washington DC area trade at a very low CAP rate, say 4% compared to if that same complex was in Charlotte, NC which might be an 8% CAP Rate.

Let’s see how this might affect the prevailing price for a property.  Suppose a property in Washington, DC has an NOI of $40,000 and is trading at a 4% CAP rate.  The property value would be calculated as $40,000/4% = $1,000,000.  That same property’s value in Charlotte, NC would be $40,000/8% = $500,000.  That’s a huge difference in cost to create that $40,000 of NOI each year.

So by the explanation above you should be able to see that for every dollar of NOI you add to a multi-family or other commercial property there is a multiple effect on the value of that property.  So in Washington DC if I have a 150 unit apartment complex and I raise the rent $10 per month then my NOI should increase by, 150 units * $10 * 12 months = $18,000.  Divide the increase in NOI by the CAP rate, $18,000 / .04 = a $450,000 increase in the value of that property.  Pretty sweet right?

That same $18,000 NOI increase per year in the Charlotte apartment complex would increase the value of that property by $18,000 / .08 = $225,000.  Which is also pretty sweet right?

To keep the discussion simple these calculations assume that there are no increased costs when the rent goes up and that the buildings are 100% occupied but hopefully you get the idea.  You can create GOLD with CRE.  Okay its value not GOLD you are creating but when you sell or refinance you can take that excess cash and buy yourself some gold!

As a side note there probably will be some increase in costs when you raise the rents.  For instance, the management company is usually compensated based on a percentage of the rent collected.  People may move to other housing types which creates the costs associated with a vacancy.  However, as long as the rent raise creates a positive increase in NOI then your property’s value will increase.

Given the fact that the value increased more with the property with the 4% CAP rate versus the property with the 8% CAP rate you might be asking yourself why we try to purchase property at a 10% or higher CAP rate.  Here are some of those reasons:

  1. A higher CAP rate generally makes it easier to attract investors into the deal (provide them a decent return).
  2. It can take less cash up front to capture the property.
  3. Safety Net: Suppose you bought a property at a 4% CAP rate and then the demand for housing in that market fell, at a 4% CAP rate an increase to your vacancies could put you in a negative position more quickly.

So I hope you can see that with commercial properties it is possible to drive the value higher and create equity in the properties.

Twitter Digg Delicious Stumbleupon Technorati Facebook Email

One Response to “What is the CAP Rate or Capitalization Rate? (Creating Gold Part II)”

  1. very educational