REPORT #2: What is Cap Rate and how does it affect the value of an Apartment Complex?
There are 3 figures that go hand-in-hand when trying to determine a commercial/apartment property's value. They are; Net Operating Income (NOI), Cap Rate (CR) and Asking Price or Purchase Price (PP). If you know 2 of the figures you can always figure out the third.
Here I'll be talking about the Cap Rate of a property. More specifically, how the Cap Rate works in conjunction with the Net Operating Income (NOI).
Let’s get started. First off, Cap Rate is short for Capitalization Rate. In short, Cap Rate is, “The process of converting anticipated future income into present value” according to the American Heritage Dictionary. It’s also your rate of return if you bought your property using all cash.
Here’s an example: If I purchase an Apartment Complex for $1M and it generates a Net Operating Income at the end of 1 year in the amount of $100K, then my Cap Rate is 10%. The formula for Cap Rate is:
CR = NOI / PP
Cap Rate (CR) = Net Operating Income (NOI) divided by the Purchase Price (PP) of the complex. Therefore, if we plug in these numbers: $100,000 / $1,000,000 = .1 or 10%. If this same complex generated $90K in NOI, its Cap Rate would be $90K / $1M = .09 or 9%. Lower income, lower Cap Rate, but the Purchase Price stayed the same.
Knowing the Cap Rate allows us to accomplish several things. First, it allows us to determine the value of the property. Second, it allows us to compare our complex to other similar complexes in the same geographical area. Lastly, it allows us to compare the ‘Cost of Money’.
In our example, our complex had a Cap Rate of 10%. If I research the average Cap Rate in a market, I want to make sure our complex falls within the average or slightly above the average Cap Rate. Let’s assume we’re purchasing a complex in Dallas. We research the area and find the average Cap Rate to be between 9%-10% for similar complexes. How does our complex compare? It’s on the high end of the average. This is potentially a good thing assuming the number’s we’re analyzing are accurate. I’ll get into that topic in another article on Due Diligence. But, for right now, let’s assume they are accurate.
One quick thing to remember, since Cap Rate is relative to the Income being generated by our complex, the higher the Cap Rate the better, when we’re buying. Think of it this way, if you had $100,000 to invest and you chose to put it into a bank savings account or CD, would you rather make 10% on your money or 8%? If both banks were equal in quality, reputation and safety, you’d probably pick the one paying 10%.
Now, let’s assume our Cap Rate was at 8% in the same market. The average market Cap Rate was 9%-10%. Is this a good deal? Probably not. You may be over paying for this complex. Would you want to purchase a $1M Apartment Complex and generate $100K a year or only $80K a year? You’d pay the same purchase price, but get a lower return.
A question you’re probably asking yourself right now is, “How do I learn what the average Cap Rate is in a market”? Good question. And the answer is, “Ask”. Contact 3-4 commercial RE Brokers and/or commercial financiers in that market and ask them. Tell them the type of complex, geographical area and quality of the complex and they should be able to give you a one half to one point average. In other words, they’ll tell you that Cap Rates range from 8%-8.5% or 9%-10% or 7.75%-8.25% or 6.5%-7.5% and so forth. Most, if not all of the people you speak with should be in the same ballpark. However, you may find that after you speak with 3-4 people, the overall range maybe slightly broader than one half to one point. i.e. 7%-8.5% or 7.5%-8.75%. You’re just looking for an average. There are other sources available to research the Cap Rate in a market too, but this is a quick, efficient way to get your bearings.
In our first example, we used our NOI and our PP to determine the Cap Rate. Then, we used the Cap Rate to compare our complex to other complexes in the area. But how about this; what if we want to refinance the complex or figure out the value for our own personal balance sheet, what then? Easy, we just swap two parts of the equation to solve for the third.
As you recall, the formula for Cap Rate is CR = NOI / PP. If we know 2 of these values we can figure out the third. In this second example we want to determine value. To do this we just modify the formula slightly to
NOI / CR = PP
Using our first example, let’s look into the future to see how we’re doing. After 5 years our NOI has increased from $100,000 to $127,600 per year assuming a modest 5% increase each year. The Cap Rate in the area is 9.5%. What’s the current value of our complex?
$127,600 NOI / .095 (9.5%) CR = $1,343,000 PP
Therefore, the value of our complex is now approximately $1,343,000. Not a bad return. What if the Cap Rate had remained steady at 10%? It’s the same formula. $127,600 / 0.1 (10%) = $1,276,000. That’s still not a bad return.
If our complex were generating an NOI of $108,555 per year and the Cap Rate in the area where this complex is located ranges from 8%-8.5%, what is this building worth? Break out your calculator; you should be a wiz at this by now!
NOI / CR = PP
$108,555 / .08 = $1,356,938
$108,555 / .085 = $1,277,118
This building’s value ranges from $1.277M on the low end to $1.357M on the high end. Did you notice that as the Cap Rate increased, the value of the building went down? That’s why you’re looking for a higher Cap Rate when you purchase. However, you want a lower Cap Rate when you sell. It’s not like you can just decide to lower the Cap Rate when you want to sell your complex though. The Cap Rate is driven by the sales averages in that market which are driven by the type of return buyers want for their investment.
It’s not uncommon to find Cap Rates in the 3%-4% range in San Francisco or New York City or 8.5%-9.5% in Kansas City. In larger metropolitan areas such as San Fran or New York, buyers pay higher prices because there isn’t anywhere left to build. They can command top dollar for rent in those markets. If the buyer wants to increase the value of their complex, they just increase the rent because they know they literally have a captive audience.
In places like Kansas City or Dallas, there’s room to build so it’s much more difficult to raise rents. Once the vacancy in an area drops below a certain level, a developer just comes in and builds another complex. There’s so much competition, it’s difficult to raise rents. The only way a buyer can get more bang for their buck is to pay less for the complex up-front. Thus, the Cap Rate is higher.
There are several things Cap Rate is used for. First, it is to determine the value of the property. Second it is to compare our complex to similar complexes in the same market. The third is to compare the Cap Rate to the Cost of Money. Many people don’t know about this concept, but you’re about to find out and it could save you thousands or tens of thousands of dollars a year.
The Cost of Money in a nutshell is, “How much is the money you’re borrowing to purchase this complex costing you”? The true Cost of Money, also known as the Loan Constant, is NOT the interest rate by itself, but for this example I will only talk about the relationship between the Cap Rate and the Interest Rate. This is where a lot of novice buyers get into trouble. If you’re purchasing a complex with a Cap Rate of 7%, but your loan is at 8% interest per year, you could still have positive cash flow, but you’re literally losing money on the money you’re borrowing. This is called ‘Negative Leverage”.
We recommend that whenever you purchase a complex you almost always want to look for a minimum 2 point spread between the Cap Rate and the Interest Rate on your loan. In other words, let’s say you find a great complex with a Cap Rate of 7.5%. That means the Interest Rate you are borrowing money at should be no higher than 5.5%. Not an impossible rate to find, but there may be some prohibitive terms connected to it. We’ll save that for another article.
Let’s look at this from another direction. What if you find your financing first and the Interest Rate is set at 6.5%? Using this information, what’s the minimum Cap Rate you want to look for when trying to find a complex to purchase? I hope you said 8.5% or higher! The larger the spread the more money you can make.
Again, if you find a good complex with a Cap Rate of 9%, what is the maximum Interest Rate you want to pay? That's right, 7% or lower. If you only remember one thing about Cap Rate after reading this article, I hope it’s this part about maintaining a 2 point spread between the Cap Rate and the Interest Rate on your loan.
This concept also comes in handy when trying to negotiate the interest rate on a seller carry-back loan. Many sellers will want you to pay top dollar in interest, maybe 8%-10%. I’ve used this concept to explain to sellers why I can only pay them 6% interest. It’s because I’m buying their complex at an 8 Cap and if I pay them more than 6% I’d be losing money. Many of them are understandable at that point, many are not. But, as an Apartment Investing mogul, it sure adds to your credibility with the seller when you can explain this to them.