The Cap Rate being what it is, a ratio combining Net Operating Income and Value/Cost, two pretty important aspects of any property, is just as easily misused by certain parties as it is used legitimately. Following are three ways Cap Rate can be misused that you should be aware of.
1. Cap Rate With Pro Forma Numbers: Given that we as humans tend to seek pleasure while simultaneously avoiding pain, we are susceptible to overestimating the upside, and underestimating the downside. Brokers and smart sellers know this, so when we ask for information about the property they ply us with Pro Forma numbers; the “best case” scenario after all the hard work and improvements have been made, knowing we will go directly to there in our imaginations and conveniently skip over all of the annoying planning, supervising, managing, and flat out hard word involved with making it that way.
The obvious problem with this is by not focusing on the current condition of the property, all the repair work and cost cutting needed, or current income of the property, the Cap Rate is distorted, as you assume it reflects the future (higher) income of the property that isn’t yet there. This leads to you not acknowledging how little the property is worth now, and consequently not negotiating as hard and giving the Seller the beating he/she rightly deserves in order to get the price down to where it makes sense.
The upshot is you pay too much for the property, and only realize it after you have taken possession and face the mountain of hard work involved with turning the property around, all the while knowing there is only a trifling reward waiting for you at the end of it all. This only has to happen to you once before you give Pro Forma numbers the contempt they deserve when provided to you by a Broker or a Seller. It’s a standard negotiating gambit on their part, and you need to be aware of it. Accept Pro Forma numbers at your peril.
2. Inaccurate Income And Expense Figures: One of the figures used to calculate the Cap Rate is Net Operating Income. The Net Operating Income is arrived at by subtracting Operating Expenses from Gross Rents. When the expenses, or rents, are not accurate the Cap Rate is not accurate, and it gives you a flawed picture of how much return the property generates, and how much risk there is associated with owning the property. Read more…
When looking at apartment deals to buy one of the most basic things you need to achieve is an understanding of what the property you are looking at is worth. If you are buying through commercial brokers, you’ll have the list price, and then there will be all kinds of ratios and measurements they throw at you to supposedly help you analyze the investment.
Any given ‘offering memorandum’ will contain Gross Rent Multiplier (GRM), Cash-On-Cash Return (COC), Internal Rate Of Return (IRR), Capitalization Rate (Cap Rate), and even more if they are really zealous.
If you are buying direct from the Seller you are confined to what you know about valuing apartment buildings, and what the Seller tries to convince you the property is worth in order for you to feel justified in paying the price he/she wants.
It’s helpful to be able to cut through waffle and get to the point, because apartment buildings are income property, and income is measured in numbers, making the analysis of them very concrete. Out of all the ratios a person throws at you to value a property, the only one that is really of any use to use is the Cap Rate, which stands for Capitalization Rate.
You calculate the Cap Rate for an apartment building by taking the Net Operating Income (NOI) and dividing it by the value of the property.
NOI / Value = Cap Rate
So if you have an apartment building that is being marketed at $7,950,000, and the actual NOI is being presented as being $650,000, the Cap rate the Seller is telling you the property generates is as follows:
$650,000 / $7,950,000 = 0.0818 x 100 = 8.18%
What this 8.18% is actually tells you is that if you had $7,950,000 of investment capital and you used it to buy this property, all cash, after twelve months had gone by and you received $650,000 of Net Operating Income, your return on investment from income in the first year of ownership would be 8.18%. If the price is decreased, or the NOI increased, the Cap rate goes up. If the price is increased or the NOI decreased, the Cap rate goes down.
How Is Cap Rate Used?
1. To Value Income Property: Due to the Cap rate being the quotient of the Net Operating Income and the Value, it is used when you analyze a property for possible purchase. When you have the “market” Cap rate, the Cap rate that like properties (same property class, area, condition) are selling for at the current point in time, you can use that to calculate the current value of the property, based on actual rents being collected on and expenses being incurred by the property (This is a number that is essential for negotiating price with the Seller). And you can calculate the future retail value of the property; the value of the property after all repairs have been made and it has been fully leased up and stabilized. With these two values you will now see the spread in the deal and know your buy and sell target values.
Property management is such an important part of successful apartment investing. Apartment buildings are income property so their value is derived from the Net Operating Income. The higher the NOI the higher the value of the property.
What determines how high the Net Operating Income is on a property? Right, property management. Keeping the units fully rented to keep the gross rents as high as possible, and minimizing vacancy and other expenses to keep Total Operating Expenses as low as possible. The two of these done together increase the NOI to its highest level.
When an apartment investor purchases a property, he or she has a choice. They can hire the best property management company they can find, and manage the managers, or, they can choose to manage the property themselves and become a landlord.
The problem with becoming a landlord for many apartment investors is they have never had any training in property management. Without this training the landlord struggles to keep tenants in line and control the property.
Instead of treating the property as a business the landlord starts being lax on the rules laid out in the rental agreement (timely payment of rent, keeping quiet at night, tenant paying for repairs up to a certain cost, keeping the property clean) and the tenants, seeing they can get away with this, start treating it as the new normal, “training” the landlord to react to their priorities, not his.
The first place this plays out is with the payment of rent. After a couple of months of owning the property a tenant call on the 5th of the month and tell the landlord the rent will be “a few days late”. The landlord reacts to this by accommodating the tenant and waiting a few days. After playing phone tag and other assorted chasing the landlord manages to recover the rent by the 15th or 20th.