CAP RATE - Using it to evaluate an investment, but also using it to calculate “forced appreciation."
Your commercial broker may tell you that your potential building may be trading at an 11 Cap in an area that averages right around the same (area cap rate is the average cap rate of all the apartments in that submarket), but what he has not shared is that according to Judgmental maps, people are “trading babies for crack” in that neighborhood. Probably not the high growth metrics you are seeking.
In commercial multifamily, you hear the term Cap Rate a lot. You will hear it described as an evaluation of an investment, or you will listen to it referred to only as a multiple. Which is it? It is both. Primarily, it reflects market sentiment for a particular asset class for a specific area. You must be able to locate this as a benchmark to evaluate your investment. Numerically speaking, the Cap Rate is the return in current income on an apartment investment you could expect if you paid all cash. Many will throw cap rate out there as a form of ROI, so the higher the cap rate, the better right - not necessarily.
Have you ever used Judgmental maps? It’s a great way of getting a quick sketch of where you are considering investing.They take a humorous (and most definitely not, politically correct) approach to assessing neighborhoods in most of the larger metropolitan areas around the country. Your commercial broker may tell you that your potential building may be trading at an 11 Cap in an area that averages right around the same. An area cap rate is the average cap rate of all the apartments in that submarket. What the broker has not shared is that, according to Judgmental maps, people are “trading babies for crack” in that neighborhood. Probably not the high growth metrics you are seeking.
Many professionals say cap rates do not matter, but I think they are referring to the purchase cap rate. The Cap Rate is a useful tool when it comes to crunching the numbers; otherwise, how will you estimate what your property is worth?
CAP RATE AS A NUMERICAL EVALUATOR OF A REAL ESTATE INVESTMENT.
Cap rate = Net operating income / Current market value (sales price) of the asset.
Net Operating Income, or NOI = Gross Operating Income minus Total Operating Expenses (items like property taxes, insurance, maintenance, property management, marketing, legal, admin). Cap rate does not include debt service (your mortgage) as an expense.
A simple example, with easy, round numbers to illustrate:
• Total gross operating income for property: $200,000
• Total operating expenses for property: ($100,000)
• Net Operating Income (NOI) = $100,000
• Purchase price for property: $1,000,000
Remember the formula: NOI/Purchase price = Cap Rate
$100,000/$1,000,000 = 10%, or a 10 Cap in commercial multi-family speak. Thus, if you paid all cash for the building, you would have earned a 10% return on your investment.
Conversely, it would help if you had the cap rate to determine what you should pay for a building. The formula for determining the value of a building?
NOI / Cap rate = Purchase price.
You can find this "area cap rate" by researching online or polling brokers. The area cap rate is the average cap rate for apartments in that submarket (your building's neighborhood).
USING CAP RATE AS A MULTIPLE TO CALCULATE HOW MUCH VALUE YOU HAVE ADDED, i.e., "Forced Appreciation," The Value Ad
Let us suppose that as a new owner, you can increase rents by $50.00 per month, per unit, without incurring any added expenses (maybe they are $50 below-market rents in the area). Let's also assume your building has 50 units.
$50.00 X 50 units x 12 months a year = $30,000 added annual revenue.
Now we start using a 10% Cap rate as a multiple to determine how much overall value we have added to our investment. First, we need the earnings rate multiple formula.
1/cap rate% = earnings multiple
In our case, 1/.1 (our 10cap) = 10x
$30,000 x 10 = $300,000.
The quicker way to the same result is to divide the added revenue by the cap rate:
$30,000 / .01 = $300,000
$300,000 increase in added value, or “forced appreciation,” to the property!
Remember, this increase in annual revenue drives up your net operating income, which will then drive up the value of your investment.
Original (NOI) $100,000 / .1 (Cap rate) = Original Property Value $1,000,000.
New (NOI) $130,000 / .1 (Cap Rate) = New Property Value $1,300,000
Congratulations, you have just increased the value of your property by 30% - no market forces needed! You created the appreciation yourself — the beauty of the commercial multifamily real estate asset class.