"And we're getting it at an 8 cap!" What?

The cap rate is one of the most commonly used metrics in Real Estate deals. This is an important number for determining the profitability of the deal, the profit targets and how much one can expect to make year over year. But what is this ever-present number and what is it's significance? Most importantly, how can you use it to make money?

### What is it?

Strictly speaking, the cap rate, or capitalization rate, is the profitability of a building or property after accounting for operating expenses.

For example, a simple Multifamily building:

Book price: $1,000,000

Annual rent: $120,000

Operating Costs(maintenance, taxes, insurance, etc.): $30,000

Net Operating Income (annual rent less operating costs): $90,000

Cap Rate: 9% (90,000/1,000,000)

As you can see, what we actually have here is a dance between three values: NOI, Book Value and the Cap rate. Understanding what these are and how they interact is the key to understanding and using the cap rate to profit.

Understanding what these are and how they interact is the key to understanding and using the cap rate to profit.

Let's take these one at a time.

The NOI, or net operating income, simply means how much money the property generates after paying basic expenses. It's just like if you were to own a microphone store. If you purchase microphones for $30 and sell them for $50, you would make $20 for every microphone you sell. This is your net profit, the amount of money you make that is actual profit. Similarly, when you own a building, you need to deduct basic expenses from your revenue to determine how much you really profit.

For example, if you have a building which generates $10,000 a month in rental income, you'll have an annual revenue of $120,000. But you don't get to keep all that money. You need to pay property taxes. You need to pay for maintenance. You need to pay utilities. Depending on the property, you may need to pay for management. All of these expenses reduce your take-home profit. Assuming all of these cost $30,000, your actual profit is $90,000. This is the net operating income, the NOI, of the building.

The book value is simply what someone will pay for the property based on its performance. If someone will pay $1MM for the building, the book value is $1,000,000.

The cap rate, or capitalization rate, measures, as a percentage, how much money the property produces for its owner over the course of a year. For example, if you were to pay $1MM for a property with an NOI of $90,000, the property would produce for you at a rate of 9% a year. In simpler terms, you would make 9% on your money.

It's important to understand how these three values interact. Which variables tend to change and which are static? Which are the one's that actually determine the other ones?

As a rule of thumb, the book price is a result of the NOI and cap rate. Let's understand what determines the NOI and cap rate, and it will become clear why this is.

As we saw, the NOI is determined by the rent rolls and expenses. But what determines the cap rate?

In short: the market.

The market determines the cap rate

### A deep-dive into what determines the cap rate

Let's back this up and try to think like an investor. Imagine that you can go to an investment store. There are different products on the shelves. Each one pays out one dollar every year. You can buy as many as you want. These machines vary in quality. Some are made from platinum and are nearly impossible to break. Some are made from cheap plastic and look like they wouldn't survive a fall. Obviously, the more solidly built machines cost more, but all the machines pay out the same dollar every year. People are willing to pay more for the platinum machines so the store owner can charge $50 per machine. No one would think of buying the cheap plastic ones for $50. In order to sell them, the store owner needs to price them cheaper. These ones sell for $10 a unit.

If you had $50, which one would you buy?

Let's analyze the two products. I you pay $50 for a machine that prints for you $1 a year, you will make an annual return of 2% (1/50). This 2% is very reliable and you should be able to sell the machine to someone later on and recover your principal.

The $10 plastic machine would net you a return of 10% a year. You could buy five of them with your $50 make $5 a year instead of $1. But the risk is greater.

This is very much how the real estate market works, just instead of money machines we buy tenanted properties and instead of a store we have the global real estate market.

So what determines what people are willing to pay for real estate? It depends on the other options.

In our investment store example, if the cost of the platinum machine were to go up (they now cost $100) and the return were to go down (now it's only earning 1% per year), the 10% a year plastic machine would look much more interesting, and the store owner would be able to charge more for that, as well, in turn lowering the return to a level that is still interesting to machine buyers. He would raise the price to $12, giving the buyer a return of 8.3% which is still significantly better than the 1% currently offered by the platinum machine.

How does this work in Real Estate?

Let's say government bonds are paying 2% ($1 annual payout on every $50 bond purchase). Corporate bonds are paying 3-4% ($1 annual payout on every $25-$33 bond purchase). How much do we need to make in order to justify the additional risk and reduced liquidity of a real estate investment? More specifically: how much do we need to make to justify that risk with this property in this market?

This thinking is what determines cap rates. This is why discussions about cap rates always start with the asset type (multi-family, retail, office, industrial), class (A, B, C, D) and market (location) and sometimes even submarket and anchor tenant. The reasoning is that investors are willing to accept the risk on properties like this one, for a return of this amount.

Let's make this a bit more tangible. In 2016, according to CoStar, cap rates in New York City, by asset type, were:

Which one of these is the most attractive asset, from an investors point of view? Which dollar of profit is he willing to pay the most for? The correct answer is Multi-family in Manhattan. For every dollar of profit the investor needs to pay $24.39. Compare that to Office in Queens, the least "safe" investment, for which people are only willing to pay $15.87 for a dollar of profit.

The single most important take-away from this is: the market determines the cap rate.

Depending on all the factors that determine the collective decision of "the market", including alternative investment options, perceived risk, appetite for risk and historical precedents, the market will determine the cap rate for a given property type in a given area.

Now we understand what determines the NOI and the Cap Rate.

The final step is to use these to determine the book price, or how much we should pay for a property.

### Use the Cap Rate to Determine the Value of Real Estate

Let's use the chart from earlier: office in Brooklyn has a cap rate of 5.6%. Let's say the NOI of the building is $100,000. How much should we pay for the building? Let's recall that the cap rate is the NOI divided by the purchase price. Arithmetically, this is the same as saying that the book price is the same as the NOI divided by the cap rate. So all we need to do to determine the market value of the property is divide the NOI by the cap rate. In this case, we would divide $100,000 by 5.6% (entered into a calculator as 100000/.056) and we would receive a book value of $1,785,714. You can easily check the math by testing for the cap rate. Divide $100,000 (the NOI) by $1,785,714 (the book value) and you'll get .056, or 5.6%.

Compare this to a similar property in Manhattan, in which office is yielding a 4.5% cap rate. This building, with the same $100,000 NOI, will sell for $2,222,222.

This illustrates a basic rule of cap rates and valuations. For a given property, or NOI, a higher cap rate will result in a lower book value. A lower cap rate will result in a higher book value. The cap rate and book value have an inverse relationship.

So by now we should have a good understanding of the NOI, the cap rate, the purchase price and how the NOI and cap rate determine the value of the building.

Now the question is: so how do we use this?

There are two basic ways to use the cap rate.

### Is this a good deal?

The first is: should we purchase this property (or invest in this deal)?

How do we use the cap rate to determine if a deal is a good opportunity?

Should you just pick the properties with the highest cap rates? As a rule: No.

Based on everything we've learned, a cap rate should be judged based on its market. Let's say we're looking at an office building in Brooklyn with an NOI of $100,000 and a cap rate of 7%. The general market is selling at 5.6%. Our first question should be: why is this property selling for so cheap? The building should be selling for $1.78MM. At a 7% cap it's selling for $1.42MM. That's a pretty steep discount.

This is where the sophisticated operator will look for a value-add opportunity. Perhaps the leases are up in a year. Perhaps the primary tenant just declared bankruptcy. Perhaps the building is 35% vacant. There can be any number of reasons for a building to be selling below market. An experienced operator will know how to determine if the situation is an opportunity or not worth the risk. If the situation continues to deteriorate, the cash flow will continue to shrink and the buyer will lose money. If the operator can come in and move the building from 65% occupancy to 95% occupancy, boost the NOI to $130,000 and, because the building is stabilized, sell it at the market cap rate of 5.6%, he will sell if for $2.32MM, a profit of $900,000.

What you may see in value-add situations is something called the "pro forma" cap rate. Pro forma is latin for "for the sake of form" and is used in real estate to mean "based on a certain model". For example, in the above example in which the property was 65% occupied. If market occupancy (what most properties are experiencing) is 95% occupancy, the seller may promote the property as a 7% actual cap rate but 9.15% pro forma cap rate. That is, based on the expected market NOI ($130,000) and the current asking price ($1.42MM), the cap rate is 9.15%.

What if the property is selling at market? The buyer should do careful due diligence to determine that the property is stable and decide if the market is right for him.

What if the property is selling above market? Unless there is something truly unique about this property that makes it worth more than equivalent properties, this situation is likely the result of a greedy or uninformed owner.

This the primary use of a cap rate: to determine if a property is well-priced, discounted or overpriced.

### For how much can I sell this property?

Another common use of the cap rate is: determining sale price.

Just like a cap rate can be used to determine the right price at purchase, we can also use it to estimate the sale price.

If the plan is to raise rents across the board by 15%, we can calculate the new NOI and sale price based on the current cap rate.

As a passive investor, one can always use this knowledge to check the operator's assumptions. If the cap rate at purchase is 8% and the operator is targeting a sale at 6% (a profit of 33%) one needs to ask if the deal justifies such a jump in the cap rate. Usually, conservative operators will assume a similar cap rate to the time of purchase. If the deal warrants a change in the cap rate the estimated new cap rates will be based on the current market. For example, if improvements are being made to the building to make it nicer, the exit price will be calculated using current market cap rates for nicer properties. If you see a significant jump in the cap rate, there had better be a good reason for it. Personally, I like to run sale estimates against several cap rates to better understand the potential upside and downside in a deal.

Recently, an investor showed me a deal from a 3rd party. I performed a quick synopsis of the deal. One detail that stood out was that the purchase cap rate was 6.5% (quite high for the city and asset type), the refinance in the second year was assuming a 5% cap rate and the sale in year 10(!) was assuming a 4.5% cap rate. Interesting assumptions that warrant further analysis.

### Conclusion

While the interplay of the NOI, book price and cap rate can seems confusing, by now you can see that the basic principles are easy to grasp. The NOI is the profit, the book price is how much people are willing to pay and the cap rate is rate of profit. We've seen how to use the cap rate when determining whether or not to purchase a property and how to use it to estimate the profit from sale.