027: The No Cap on the Cap Rate
It’s a new week at one of our favorite places to be: with our Cashflow Multipliers Team!
It’s truly one of our favorite parts of the week. And can you believe we’re already nearing summer? Honestly, it’s freaking us out seeing all of these florals and summer menus. But we are not hating this warmer weather. And you know what the best part of summer is, right?
🏝️🏖️VACATIONS‼️ We’re a little later in the year now, and if you’re anything like us, you already have your summer plans locked and loaded.
We are so excited about the trips we have planned coming up this year! 😵😵
One of the biggest reasons we love what we do is the simple pleasure of packing up our bags any time of year and enjoying our money work for us while we’re chilling in the Maldives, Dubai, or even Greece!
And as much as we love traveling, what we can’t stand is being unprepared. 🥵🥵
Anyone who has been to a country that’s foreign to them knows the pain, struggle, and perhaps awkward encounters of not knowing the language. All of a sudden, trying to get directions becomes a flurry of opening up the translator app on your phone and lots of hand gestures. Been there, done that.
You know what else can feel like that? Starting out in apartment investing. Everyone around you knows the terms, the vocabulary, and insider lingo and you’re sitting there thinking if you’re ever going to make it in this business, much less learn the language.
It’s not Greek speak, it’s Geek-speak.
Hi, we’re the geeks. And we get it, starting out in multifamily real estate can be incredibly overwhelming. But here’s a pro tip for you: Taking the time to understand a few keywords and concepts at a deeper level in this space will set you up for success in the long run.
If you haven’t already, we highly encourage you to check out 🎙️ EP017 of the Cashflow Multipliers Podcast: The Nine Numbers You Need to Know. There, we breakdown the nine crucial numbers to start your passive income journey in apartment syndication. And one of the numbers we went over was called the capitalization rate. Capitalization rate AKA “cap rate” for short, is one of those terms.
As the kids are saying these days: No Cap.
And if you’re wondering what that is, according to or Tik Tok binging we’re pretty sure it has something to do with telling the truth. Like, you’re looking really good today. No cap.
We guess in some ways we’re still learning new lingo too.
The cap rate we’re talking about is often referred to as “the gold standard” by commercial real estate investors as a way to get a high-level understanding of a particular investment property. There’s a lot of information packed into this one number.
The best way to break down this number is through simple math that can be done on the back of a cocktail napkin. That will give you a quick snapshot evaluation of an investment property.
We think a lot of us remember simple math formulas from high school like mx + b=y. Simple, in theory, as their just variables. However, they can quickly escalate to very complicated math formulas that leave us doing all-nighters cramming for a test.
Similarly, so is the cap rate. A simple formula but understanding the nuances of this term is what makes it complex, and at times, overwhelming. And thankfully, our long nights are behind us.
The other good news 👉 is that as a passive investor, it’s not your job to get into the weeds of the formulas involved in the cap rate. You can leave those nuances to us, your General Partners. When you tune into the webinar, we break down the numbers and show you the end result.
Call us The Hulk because we’re doing nothing but crunching numbers over here. 👅 Of course, we know you’re totally capable of knowing and learning the numbers yourself so you can invest confidently.
Early on in our apartment investing journey, it took us some time to really start to understand how and when to use the cap rate analysis and why it can be powerful in determining the future value and return on investment.
So our goal for today’s episode is simple: Help you understand the cap rate, how it’s used, and elevate your apartment investing game. No cap.
Understanding Cap Rate
Alright, let’s get our hands dirty with the nitty-gritty of what a cap rate is. The first step is knowing what it is and how to calculate it, and believe it or not, there are actually a few definitions and calculations.
Good old Investopedia has the definition for us. According to them, the cap rate is defined as the most popular measure through which real estate investments are assessed for their profitability and return on potential.
Essentially, the cap rate indicates the financial return that an asset will bring in each year in the form of a percentage– not dollar amounts. The cap rate will determine how much you can expect to receive back in yearly rental income, for every dollar the property costs you to acquire. It is a snapshot of the property’s potential, indicating both the quality of the investment and the assumed risk. 👈
We’re starting to think of this as the “stories” highlight feature on Instagram. Everyone’s potential and the good side are on display for all to see.
Kind of, but the cap rate also shows the side many don’t see on Instagram, the risk and not-so shiny parts of people’s investments should worst-case scenario occurrences happen. God forbid, obviously. But, at least it’s calculated in the cap rate.
Okay so how do we calculate this percentage? In previous episodes, we told you that the cap rate is determined by the NOI.
Can you remember what NOI stands for?
If you said Net Operating Expense– a big Kitti Congrats! 🤩🤩
So the cap rate is determined by the NOI and dividing it by the value of the asset. In some cases, this value is what you paid for the property. In others, it’s what you plan on selling it for. For reference, your NOI is all of the revenue from a property, minus the necessary operating expense.
The Two Best Calculations to Determine the Cap Rate
Net Operating Income (NOI) = Real Estate Revenue – Operating Expenses*
Cap Rate = NOI divided by the Property Value
A note here: Debt service (or the mortgage payment) for a property is not included in the NOI calculation and therefore, not used to calculate the cap rate. But your mortgage is a payment expense.
Loans vary from property to property and investor to investor, therefore it would be nearly impossible to use a consistent calculation that takes debt service into consideration without skewing the cap rate. In this case, we approach defining the “Property Value” number as if we paid in cash.
Like we said, the formula is simple but the math varies. Let’s take a look at an example. ⬇️ ⬇️
You purchase 200-unit multifamily at $20M.
The current NOI (Real Estate Revenue – Operating Expenses) is $1M.
NOI ($1M)/ Property Value ($20M) = Cap Rate
$1,000,000 / $20,000,000 = 0.05 or 5% cap rate.
If these numbers are swimming in your head as we’re saying them, no fear. Be sure to check out the show notes on our website thekittisister.com to see a better breakdown.
What Makes a “Good” Cap Rate?
All of this talks about cap rates and calculations– how do you know if it’s good?
The short answer is that it all depends on how you are using a cap rate. For example, if you are selling a property then a lower cap rate is known as an “exit cap rate”. And you know it’s a good rate because the value of the property will be higher.
On the other hand, if you’re buying a property that’s known as “entry cap rate.” You know the number and calculation is worth it for you if the initial investment number is lower.
Entry Cap Rate
Let’s talk about red flags for a second. We may be terrible at spotting them in people but we absolutely can see them in low cap entry rates. Entry cap rates can also be called “going-in cap rate” or “initial yield” and it’s the best way for an investor to evaluate if the asking price is within reason. This is where the red flag comes in. A low cap rate percentage could indicate several red flags, specifically an asking price that is too high for the given market.
A lower cap rate, and we’re talking anything under 3%, could also indicate that the property is under rented and therefore, yielding a lower NOI.
Now while we want the highest possible cap rate when we buy, for us, the Kitti Sisters, that isn’t the only metric we look at. Ideally, we’d want to buy in markets with slightly above National cap rate averages; however, given the consensus amongst the top real estate experts that in hot markets such as DFW, Phoenix, Atlanta, Houston, etc. All markets that we love 🧡🧡. The cap rate will continue to compress, which means it will continue to go down in the next future year.
Think Toledo Ohio vs Phoenix Arizona. Phoenix will generally have a substantially lower cap rate, but it’s also a significantly better market that will yield better overall performance and returns.
Let’s take that same example from earlier. ⬇️ ⬇️
A $20M property that has an NOI of only $500K (instead of $1M like the earlier example), the cap rate drops from 5% to 2.5%.
That’s half of the Net Operating Expense.
You can see now how that 2.5% can be an indicator that the NOI is pretty low compared to the price of the property. An under-rented property offers room to increase rental income, thereby increasing NOI and increasing the cap rate.
A value-add property may have a lower cap rate, as there is the opportunity to increase the property value (or your NOI) with the right renovations. On the other hand, a stabilized property with little to no upside potential will typically yield a higher cap rate percentage.
We get it: It’s a tough choice. There are pros and cons to both sides and it’s difficult to know which choice is “right”.
We didn’t choose this cap life, it chose us.
Here’s a key thing to remember as well 〰️ the cap rate is still market-specific and can vary deal by deal. And it doesn’t necessarily indicate if a deal is “good” or “bad” if you just skim the surface without understanding why you’re getting that number.
Here’s what we would say about trying to understand that number. It really depends on your strategy and what kind of opportunity you are looking for as an investor. We’ll give you a real-life example. Recently, in Dallas Fort Worth, class B assets were at a 3% – 4% cap rate. This was because these assets were incredibly overpriced. Again, this doesn’t mean it’s a bad investment. This type of investment may be appealing if you are looking for a predictable asset with a good return in a historically strong renting market.
Plus, everything is bigger in Texas, just like their NOI. 😂😂
Bigger doesn’t necessarily always mean better. However, now that you know the basics let’s look at how the cap rate equation can be flipped around to answer different questions. For example, if you know that the market cap rate in a particular area is 6% for the asset class you’re looking at, you could move the numbers around to determine a reasonable offer on the desired property.
Let’s go back to our original example of a property ➡️ ➡️ with $1M in NOI. Knowing that the market cap rate is 6%, divide the NOI by the 6% market cap rate to determine your offer. Adjust accordingly based on the current market cap rate specific to the property’s asset class.
So that $1M divided by 0.07 = $16,666,666.70.
Varying factors can significantly change the capitalization rate including rental income, vacancy rate, current expenses related to the property, market valuation, and value-add potential.
That’s a lot of things to consider, and dare we say it, homework to do with your team to measure if the investment is worth your time and resources.
As the investor, understanding that the cap rate could indicate a variety of different scenarios, it is your job to dig deeper to find out if the property is worth your time, energy, and effort and how you could increase your return on investment.
Going back to our original example, let’s assume you completed a set of value add projects and increased the rent as a result. So for all of you who remember last week’s podcast, that’s like putting in renovations on a Class B property and upping its value in the neighborhood.
The projects allowed you to increase your NOI from $1M to $1.2M annually. And the market cap rate is still 5%.
Remember, we’re going back to the original example where we found our cap rate for this property to be 5% because NOI was $1M and the purchase price was $20M.
Using this new NOI and the same cap rate, you can increase the property value to $24M, which is a 20% increase (or $4M more) from the original purchase price.
Just by rolling up your sleeves and channeling your inner Joanna Gaines.
Or, hiring her yourself! We dream big around here.
So what’s the math on that?
$1,200,000 divided by 0.05 = $24,000,000 ($4M greater than the original $20M purchase price)
If you’re ever wondering how apartment syndicators are getting these 80-100% return on investments in 5 years, the magic is in the cap rate!
Definitely a new spin on pulling a rabbit out of your hat– or cap.
You can see how just an annual $200K increase in NOI resulted in a $4M increase in the value of the property, and how leveraging debt to your advantage allows you to maximize your returns. It’s also why it’s critical to know your market cap rate when doing these kinds of calculations.
Exit Cap Rate
Okay so we talked a lot about the entry rate, but we didn’t forget about the exit plan. AKA the exit cap rate. Let’s break it down in more detail.
Exit cap rate is used to calculate the future price of a property based on its expected NOI at the end of the investor holding period, or at the time of resale.
Like when you’re ready to put up that “For Sale” sign and see how much you’ll be making.
The exit cap rate is used to get a “rough” estimate of the future value because truthfully no one really knows what the exit cap rate is until a property is about to be sold. This tends to get a little tricky because it’s really not that important of a number. At The Kitti Sisters, we always underwrite conservatively so we will add at least .05 or more basis points to the entry cap rate to determine the exit cap rate.
What we’re doing here is managing expectations in case anything were to go wrong, or we didn’t expect the return we were anticipating. This helps us to not let our hopes get up too high but, oftentimes, they do work in our favor.
A prospective buyer may use a projected exit cap rate to determine future capital gains on the asset. Estimating the future cap rate of a specific property is a delicate and highly technical task. The estimate should be done using econometric analysis and historical cap rates at the market and property type level.
An exit cap rate lower than the entry cap rate will typically result in a net gain due to the increase in property value.
So we’ll end with this, depending on your role in apartment syndication, understanding the cap rate, how it works, and what to expect will either be the most important thing or really not that big of a deal.
Right, when you’re a GP in an advantageous position to negotiate the purchase price, increase profits, and collect future profits upon resale, this information will be given to passive investors as a great investment opportunity.
On the flip side, for you passive investors 👉 if your head is spinning after all the formulas and calculations here– take a deep breath and exhale slowly. Leave these to the GPs. It takes time to learn these concepts, just like learning Greek‼️
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