CAP Rates for a dummy
Hi all. First post here and a total newbie to CRE. Can anyone please provide a simple explanation and a few examples of what CAP rates are and how they work? Thanks! 
[{"id": "e52jqh9", "text": "It's a super simple way of expressing the value of real estate based the income it generates. It is essentially treated as a perpetuity and the present value is determined by taking the net cash flow generated  (excluding debt service) and dividing by the yeild. Ie a property generating $100,000 net income sold for $1,000,000 would generate a 10% cap rate (yeild). \n\nThis allows for a fairly quick comparison of potential real estate value by expressing the VALUE of the income as a rate of return that an investor desires to generate. Riskier income requiring a higher cap and safer income demanding a lower cap rate. The compression or expansion of cap rates can indicate trends in the industry and drive further investment or divestment to or from a particular asset class. \n\nMore complex methods of determining value rely on net present value calculations with detailed costs, income, capex factored over a long period of time and rely on a number of assumptions predicting certain variables. This method requires extensive information, experience and knowledge. \n\nOnce a property sells the cap rate can be used as a comparison to other similar properties and income types.\n\nUnderstanding how cap rates work is fairly easy. But learning the subtlties of what influences influences cap rates takes experience and knowledge. When used effectively you can strategically lease/develop properties to demand the lowest yeilding cap rates and therefore maximize the value of your real estate.", "replies": [], "depth": 1}, {"id": "e52jxar", "text": "Basically the rate of return on a property. Cap rate = net operating income/current market value. \n\nhttps://www.investopedia.com/terms/c/capitalizationrate.asp gives a good summary.", "replies": [{"id": "e54zefx", "text": "That is an incorrect definition.", "replies": [{"id": "e5a65x4", "text": "When thinking about cap rates in terms of rate of return, a better definition might be the annual pretax rate of return on a real estate asset purchased without debt.  Basically the rate of return before paying debt service and income tax. Even better definition:\n\nCap Rate = NOI / Purchase Price", "replies": [{"id": "e5a9lc5", "text": "$50,000 NOI in Indianapolis may sell for $500,000 at a 10% cap rate.\n\n$50,000 NOI in SF may sell for $1,000,000 at a 5% cap rate.\n\n$50,000 NOI in Alabama may sell for $333,333 at a 15% cap rate.\n\nWhich property is more profitable?  A cap rate cannot tell you that.\n\nIf you think it is a rate of \"return\" then the market  would buy in Alabama to get the higher (15%) \"return\" when in fact they are buying in SF and paying more for the exact same NOI creating the market 5% cap rate.  \n\nCap rates merely reflect the supply and demand in a market.  It does not measure \"return\".", "replies": [{"id": "e5c4mvx", "text": "I agree that the cap rate can\u2019t tell you profitability. To get a profitability margin you would need to divide the profit (operating profit, pretax profit, or net income) by the gross revenue. The Indianapolis, SF, and AL properties could all have different gross revenues and therefore different profitability margins. But if you are a cash investor, and hypothetically NOI stays the same as the last year, why wouldn\u2019t you choose the Alabama property by investing $333,333 to generate $50,000 NOI instead of investing $1,000,000 in SF to generate the same NOI? I know a more detailed pro forma should be developed and there are a lot of assumptions here, but all things being equal, and assuming we\u2019re buying a fully stabilized income producing property, it seems like AL would be the better investment.", "replies": [{"id": "e5c69m7", "text": "&gt;  it seems like AL would be the better investment.\n\nAnd yet ALL the market participants are telling you the opposite.  Look at it from the sellers perspective.  Why would he sell $50,000 NOI for only $333,333 and instead hold out for $1,000,000?\n\nBut basically it is probably because there is no rent growth in Al.  Cap rates only look at one year.  It could also be a dying city so it is anticipated that vacancy will be increasing.  Cap rates also do not take into account capex expenses.  Severe weather generally creates higher capex. It might take a 100,000sf building to get $50,000 NOI in AL but only 20,000sf in sf.  100,000sf buildings have more capex.  Also you have to look at supply and demand.  SF is a constrained building area.  I'm sure  there are plenty of building sites.  Basically SF is just a more profitable area.  NOI is not profit.  You can probably think of even more reasons. ", "replies": [{"id": "e5c7n5x", "text": "You are bringing in assumptions because we have labeled the three investments by geography. If we remove the assumptions by saying that all three properties are located in SF and like I said all things being equal, meaning equal rent growth, equal capex, etc., the \u201cAL\u201d property would be the best investment. But this is basically impossible, as you are saying, because the market would drive down cap rates based on demand, as the seller will hold out for the $1,000,000 sales price, so all three properties should end up with the same cap rate.  But perhaps you have a motivated seller or some other opportunity that gets you a lower purchase price and therefore a higher cap rate, then perhaps in theory the cap rate could be helpful information. But I guess the bottom line is that it\u2019s very limited.", "replies": [{"id": "e5c8y96", "text": "&gt; some other opportunity that gets you a lower purchase price and therefore a higher cap rate, \n\nSo Grandma sells you her $50,000 NOI for only $800,000 because, well you are the favorite grandkid.  $50,000/$800,000=6.25% cap rate.  The market cap rate was 5% but you have now created a cap rate comp of 6.25%  Cap rates are analyzed by third party companies that talk to all the participants and publish for their members.  So now I go next door and tell the seller I want his $55,000 NOI for $880,000.  He's gonna tell me he ain't my grandma and I need to buy at a 5% cap rate.  \nThere will always be motivated sellers and motivated buyers.  The market tends to smooth things out.  If the market cap rate is 5% then a property on the open market will have buyers trying to test that cap rate.  If a seller accepts then maybe you got a deal or maybe you bought at the new market cap rate or maybe even paid more than the next buyer in that market.", "replies": [{"id": "e5cbfiw", "text": "So the 6.25% cap rate on Grandma\u2019s property should be evidence that indicates buying Grandma\u2019s property is a good investment in a 5% cap rate environment, right? Cap rates may be in a state of flux, so you can\u2019t know for sure, but this is at least some evidence to consider when making an investment decision?", "replies": [{"id": "e5cdkv3", "text": "Yeah, that is exactly what cap rates do, value NOI. It is a comp.  Buying under market generally is always good.  The problem with most people is that they think they are a return.  Someone was posting the other day that he targets 20% cap rates.  That means he is buying in the most undesirable areas.  Or maybe even better/worse, someone that targets 10% cap rates in a 12% cap rate market.\nNow the thing with Grandma is guess who is going to be sitting next to her at the next 20 Thanksgiving dinners.", "replies": [{"id": "e5cecrh", "text": "When you factor that into the equation, it sounds like a very poor investment.", "replies": [], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e52k5uy", "text": "The most basic mixup I see is people assuming that the higher the cap rate the better when in fact the opposite is true.  Putting it very simply you want to buy a property at a high cap rate and sell it for a lower cap rate.  With a lower cap rate You effectively are getting more sales price for the same dollar of NOI.  I'm in the hospitality space and cap rates are in the 7-8 range for quality average assets.  Trophy properties in CBD can be well below that and the junk out in no where can be 10 or higher.", "replies": [{"id": "e52tvia", "text": "I know what you\u2019re saying, but there is no good or bad cap rate.  It\u2019s about risk tolerance.  In simple terms, it\u2019s like loaning money to someone for 10 years.  Joe Shmoe with a low credit score and history of defaults gives me a higher return but also higher risk than loaning money to Warren Buffett.", "replies": [{"id": "e52ufwk", "text": "I dunno...not sure if I would want to loan money to this guy. \n\nhttps://m.youtube.com/watch?v=P-iJHGDS7RY", "replies": [{"id": "e52uh7g", "text": "Lol, maybe I should have chosen a better example :)", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e52kne0", "text": "Cap rates are versatile metrics that measure numerous aspects of a property at once. Everyone commenting here is correct even though they each have different comments.", "replies": [], "depth": 1}, {"id": "e52o8kg", "text": "Let's say I buy a small building for $1,000,000.\n\nThat property's annual Effective Gross Income is $175,000.  \nIt costs $75,000 the first year to operate the property.  \nI finish the year with a Net Operating Income of $100,000.  \n  \nIn this scenario, my cap rate is 10%  \n  \nNOI / Sale Price = Cap Rate  \n  \nWhile higher cap rates have the potential to generate more income, that comes at the cost of higher risk.  \n Alternatively, a lower cap rate should imply a safer position... If you took the $1,000,000 from above and purchased something like a CVS or Walgreens at a busy corner, you would expect a MUCH lower cap rate. But you aren't likely to find a CVS or Walgreens on a popular corner for $1,000,000.  \n  \nHowever, in this fake scenario, our rich uncle gave simple instructions: \"go out and find me a property where I'm making $100,000 a year NOI... no surprises, I want a steady stream.  I'm willing to pay what's necessary for security.\"  \n  \nYour research of the market indicates that single-tenant buildings with a credit-worthy tenant on a long-term lease is generally trading at around a 5% cap rate.  \n  \nIf NOI / Sale Price = Cap Rate  than  NOI / Cap Rate = Value  \n  \nSo to tell uncle moneybagz how much money he needs for such an income stream, we do the following:  \n  \n$100,000 / 5% = $2,000,000  \n  \nUncle needs to get ahold of $2,000,000 to buy this killer opportunity we found him.  \n  \nUnfortunately, the $100,000 NOI generated from our $2,000,000 purchase at a 5% cap rate doesn't all go straight to the owner's pockets.  The only expenses that have been paid for at this point are normal day-to-day operating expenses... we also need to pay the mortgage and make a few improvements to keep our building somewhat comparable to all the nicer, newer stuff around (capital expenditures).  And then from that figure, we need to further deduct our tax liability.  Fuckin hassle, right?  \n  \nNOI is an important metric because it tells you what your Operating Income SHOULD be under stabilized occupancy and prudent management... but it's only part of the story, as debt service, improvements (upgrades), and tax liability also need to be deducted to determine your After Tax Cash Flow.", "replies": [], "depth": 1}, {"id": "e52orgg", "text": "A cap rate is a ratio that represents the rate of return an investor will need to earn based on the risk of buying a certain property. The riskier the property type and the market, the higher the rate of return will need to be to attract a buyer at a given price. Conversely, a very low risk investment can be sold for a very low return on investment because it's relatively \"safe\".\n\nIt's based on a snapshot of current net income / acquisition price, so it's weakness is that it doesn't take into account things like future rising rents or losing a tenant, but it's a quick way to compare very different investment options.", "replies": [{"id": "e6j25eb", "text": "&gt;The riskier the property type and the market, the higher the rate of return will need to be to attract a buyer at a **given** price.\n\nWhere are you coming up with this given price?  Think about what it is really measuring, the desirability of the NOI.  Am I getting a better \"return\" or just a NOI at a cheaper price.  It is the purchase price that makes the cap rate higher.  It is not the cap rate on the property that makes the price cheaper.  Investors buy NOI, not cap rates.\n\n&amp;#x200B;", "replies": [{"id": "e6j2v8v", "text": "For a given building, you are correct. It's just a different way of thinking about the same thing. If I have $10M dollars to invest in whatever building I want, the riskier the building I am looking at the higher my rate of return will need to be to justify that investment, in other words, a higher NOI and thus a larger cap rate.", "replies": [{"id": "e6j52z2", "text": "&gt;the riskier the building I am looking at the ~~higher my rate of return~~ **Lower my purchase will**  be to justify that investment  \n&gt;  \n&gt;a ~~higher~~ same NOI and thus a larger cap rate.  \n\nA cap rate is not a rate of return.  If you buy NOI at 10% you are not guaranteed a 10% return.", "replies": [{"id": "e6jmnl4", "text": "I understand that, cap rate is only a crude means of comparing different buildings without taking into account variable income over time, cost of capital, etc. But whether you are investing a fixed amount and determining what NOI you will require for that amount, OR you are looking at a fixed NOI and determining your purchase price, the cap rate acts as a way to measure the ratio between those two numbers. And in fact, that's all a cap rate is... a ratio between NOI and purchase price at a moment in time.", "replies": [{"id": "e6jrfs3", "text": "&gt;A cap rate is a ratio that represents the rate of return an investor will need to earn based on the risk of buying a certain property.\n\nBut earlier you stated is was a rate of return.  But now you are correctly stating , \"in fact, that's all a cap rate is... a ratio between NOI and purchase price at a moment in time.\"  See how that can be confusing?\n\nYou also state, \"means of comparing different buildings\".  How does it do that?", "replies": [{"id": "e6kvy1q", "text": "You can compare the ratio of purchase price vs. NOI from one building to another.", "replies": [{"id": "e6kw9m7", "text": "&gt; You can compare the ratio of purchase price vs. NOI from one building to another.\n\nWhy would you want to compare cap rates on sold buildings.  If they are in the same market they should be pretty similar anyway.  Seems like a waste of time.", "replies": [{"id": "e6kwefh", "text": "Cap rates on buildings for sale. There can actually be quite a range depending on building condition, vacancy, etc. depending on the product type.", "replies": [{"id": "e6kx5zd", "text": "&gt; Cap rates on buildings for sale. There can actually be quite a range depending on building condition, vacancy, etc. depending on the product type.\n\nBuilding for sale don't have cap rates because they don't have a sales price. R=I/?  See, it doesn't work.\n\nAsset class can change the cap rate just like market and time BUT condition and vacancy do not change the cap rate.\n", "replies": [{"id": "e6kxckj", "text": "Buildings for sale have an asking price that cap rate can be based on. Condition and vacancy DO impact the cap rate, because they can impact the risk profile for a building and thus the return a market rate buyer will demand.", "replies": [{"id": "e6kxfkx", "text": "&gt; Buildings for sale have an asking price that cap rate can be based on.\n\nSo you buy at asking price?", "replies": [{"id": "e6kxp5m", "text": "No, but it gives you an idea what the seller is looking for, and if they are being realistic. If the are asking for a 5 cap, maybe I can buy it for a 6. If they are asking for a 4 cap, it's good to know they are dreaming. If they are asking for a 6.5 they are ready to make a deal.", "replies": [{"id": "e6kymu4", "text": "&gt;  If the are asking for a 5 cap, maybe I can buy it for a 6. If they are asking for a 4 cap, it's good to know they are dreaming. If they are asking for a 6.5 they are ready to make a deal.\n\nIf the cap rate comps are all near 3% all 4 of your non supported cap rates mean nothing except one of you is probably going to get screwed because you do not understand cap rates.", "replies": [{"id": "e6l4uts", "text": "If the market dictated cap rates were 3%, and those were the comps, you would be correct.", "replies": [{"id": "e6l6cbu", "text": "&gt; you would be correct.\n\nExcept you muddled the calculations with 4 different numbers by ignoring the market cap rate.", "replies": [{"id": "e6lsvze", "text": "Some product types trade in a wide range of cap rates.", "replies": [], "depth": 17}], "depth": 16}], "depth": 15}], "depth": 14}], "depth": 13}], "depth": 12}, {"id": "e6kxtdh", "text": "&gt;  Condition and vacancy DO impact the cap rate, because they can impact the risk profile for a building and thus the return a market rate buyer will demand.\n\nNope!  You would over valuing the vacancy by capitalizing it.  If a building has a 90% occupancy in a market that considers 95% stabilized you would value the property as if stabilized (NOI at stabilized vacancy)/market cap rate = value LESS cost and lost rent to get there as a below the line adjustment that will = the adjusted purchase price.  The cap rate stays the same, the sales price is adjusted.", "replies": [{"id": "e6ky5c8", "text": "Commonly you would apply a Cap Rate based on the in-place NOI upon purchase and the pro-forma NOI for what you think you can sell it for once stabilized, often at a lower cap rate because the risk is lower for a building that has already been redeveloped and filled with creditworthy tenants.\n\nObviously a cash flow analysis is going to be far more accurate, but the above is done all the time. I've sold many dozens of buildings, the cap rate does not stay the same. Maybe for only 5% swing in vacancy as you describe the cap rate would be extremely similar, but for full redevelopments that is not the case.", "replies": [{"id": "e6kyenl", "text": "&gt;  Maybe for only 5% swing in vacancy as you describe the cap rate would be extremely similar, but for full redevelopments that is not the case.\n\nNOPE!  Show me how you would value a new vacant building in a 10% cap rate market.", "replies": [{"id": "e6l4fma", "text": "A vacant building has zero income, so a cap rate would only apply on a pro-forma basis. If you calculated the potential income of that property, once fully leased, a stabilized cap rate for that property type could be applied to determine a rough potential sale value.\n\nOf course cost the of capital, carrying costs, commissions, ti, tax changes, zoning, etc. could all factor in to the actual IRR. A cap rate is only a simplistic tool. Nonetheless, a near vacant building would sell at a very different cap rate than a near full one. Also a factor is if the existing leases are below market rate or not.\n\nedit: Also local conditions and product type play a huge role. In my market, nothing sells for a 10 cap, no matter the NOI or condition.", "replies": [{"id": "e6l65q3", "text": "&gt; Nonetheless, a near vacant building would sell at a very different cap rate than a near full one.\n\nNope.  Convince me.  You will not be able to.  You think this is so but you can not show me how this happens.", "replies": [{"id": "e6lt0pc", "text": "Again, it's product type specific. I have sold very similar buildings for anything from a 4.5 cap up to a 6.5 cap on current income purely because they had different risk profiles due to current lease structures. For what it's worth, I primarily sell value add office buildings, which are somewhat unique in this regard.\n\nHere's an easy example. Let's say a fully stabilized building would trade for a 6 cap. But this building has all short-term, well below market leases. Because the income could easily be increased 50% or more with some re-tenanting and minor building renovations, a buyer is willing to purchase the fully leased building at only a 4.5 cap on current incomes, because they know there is value-add. But it's not as simple as just selling it for a pro-forma 6 cap if you replace everything with market rates. There is risk and cost to replacing those tenants, so that cap rate, even on a proforma basis must be adjusted to account for that risk. Maybe it's a pro-forma 7 cap, based on the purchase price, for example.", "replies": [{"id": "e6m75mc", "text": " Let's put some real life numbers to this and I will show you where you are going wrong.  Nothing too complicated but realistic.  No big hurry but over the next few days.  You did not follow up on how you would value a vacant new construction office building.\n", "replies": [], "depth": 18}], "depth": 17}], "depth": 16}, {"id": "e6xlhye", "text": "&gt; edit: Also local conditions and product type play a huge role. In my market, nothing sells for a 10 cap, no matter the NOI or condition.\n\nPlease show how NOI or Condition changes the cap rate.", "replies": [], "depth": 16}], "depth": 15}], "depth": 14}], "depth": 13}], "depth": 12}, {"id": "e6okgqb", "text": "&gt;Condition and vacancy DO impact the cap rate\n\n\u2026\u2026\u2026\u2026\u2026\u2026\u2026.A...\u2026\u2026\u2026\u2026.                   B...\u2026\u2026\u2026..              C\n\nPGI           100000      100000       100000\n\n5% v/c       95000        95000          95000\n\nOpEx          40000        40000          40000\n\nDef Maint.                     10000\n\nnoi               55000        45000          55000   8% cap\n\nMV             **687500**      **562500**        687500\n\n10000\n\n**677500**\n\n115000\n\nWell I'm not able to get the columns to work but this is a simple valuation done three ways.  $100,000 PGI   5% v/c  and $40,000 in operating expenses.  In the middle incorrect valuation the deferred maintenance of $10,000 is calculated above the line and the third valuation shows correctly how you would value the property correctly at the market 8% cap rate and THEN subtract the $10,000 deferred maintenance as a below the line adjustment.  The middle, incorrect valuation discounts that $10,000 and expects the seller to discount the sales price by $115,000 instead of the correct amount, $10,000.", "replies": [], "depth": 12}], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e52vkov", "text": "IRV!\n", "replies": [], "depth": 1}, {"id": "e585von", "text": "V=I/R\n\nA cap rate ONLY measures the supply and demand for NOI for a particular asset class in a particular market at a particular time.  It is not a return.  It does not measure profitability.  It is a method of valuation using the income approach to value.  It is really only helpful to value properties that have NOI's that consist of above and or below market long term leases.  If your property is not encumbered that way you can use the much more accurate direct sales comparison approach to value.\n\n$50,000 NOI in Indianapolis may sell for $500,000 at a 10% cap rate.\n\n$50,000 NOI in SF may sell for $1,000,000 at a 5% cap rate.\n\n$50,000 NOI in Alabama may sell for $333,333 at a 15% cap rate.\n\nWhich property is more profitable?  A cap rate cannot tell you that.\n\nAn investor will NEVER need to calculate a cap rate.  Cap rate comps come from professional third party companies that evaluate CLOSED sales.  If you have these comps then you can come to a probable market value of the NOI you are interested in.", "replies": [], "depth": 1}]