How the relationship between DSCR and Cap Rate affects your loan sizing
[{"id": "e0a4ygb", "text": "\"Buy value\\-add\u200a\u2014\u200aif you can \u201cincrease the cap rate\u201d on a property you own, \"  This makes no sense.  Why would anyone even want to increase the cap rate on a property they own.  Stupid.", "replies": [{"id": "e0a7d56", "text": "I think the author is saying you should try to increase the yield on cost by buying value add, rather than the increasing the exit cap rate as interpreted.", "replies": [{"id": "e0a7u84", "text": "But the author specifically said \"increase the cap rate\".  Someone that is that bad at communicating should not be writing a financial blog.  ", "replies": [], "depth": 3}], "depth": 2}, {"id": "e0aelx4", "text": "They\u2019re talking about going in cap rate on value add vs stabilized cap rate during the hold period. So you buy that NYC MF deal for $10M at 4.25% cap and are able to kick up the rents to $550,000 NOI, you have stabilized the deal at a 5.5% cap. You\u2019re still going to turn around and sell it at 4.25% cap for around $13M if you can though. ", "replies": [{"id": "e0aojfv", "text": "Where does the 5.5% cap rate come from?  A cap rate measures the value of a NOI.", "replies": [{"id": "e0attzm", "text": "While you\u2019re technically correct in the sense that cap rate is short for \u201ccapitalization rate\u201d and therefore is a measure of price relative to NOI at the time of sale, the vast majority of folks in the business (at least from my experience as a relatively seasoned Southern CA based retail investment sales broker) use cap rate interchangeably with \u201cyield\u201d in any given year of a holding period\u2014 which is what I think you\u2019re getting at. \n\nDoes that make sense? ", "replies": [{"id": "e0b0wx2", "text": "A cap rate merely measures  the market demand for NOI.  The lower the demand the higher the cap rate.  If you are trying to say a 10&amp;#37; cap rate market means that these properties \"yield\" more (are more profitable) than a market where properties sell at a 5&amp;#37; cap rate then you would be wrong.", "replies": [{"id": "e0bb2dq", "text": "What are you talking about? That\u2019s exactly what it means. A higher cap rate means you\u2019re getting more NOI per $ spent. Obviously it\u2019s a higher risk(specifically beta risk for the finance-types), but a higher cap rate definitely means a higher yielding investment in general. A property with a 5% cap rate are definitely less risky therefore people are willing to expect a lower yield. Yield is a finance concept regarding the return on investment, which a cap rate definitely estimates. Obviously other factors are in play, that\u2019s why most institutional investors have gone to using DCF over a Direct Cap when making their bids, but the cap rate tries to capture the less tangible things like expected rent growth, etc. ", "replies": [{"id": "e0cbq3e", "text": "No, a higher cap rate means the market is paying LESS for the CHANCE at the EXACT same POSSIBLE NOI.  Why wouldn't EVERYONE pay less for more?  Although cap rate only looks at a 12 month period an investor is going to look beyond that time frame.  There's no way you'd pay the same for $100,000 NOI IN SF as you would in INDY.  You would assume higher rent increases and greater demand, easier turnover on the SF property.  All you have to do is look and compare rent growth in the two cities.  SF blows the doors off Indy.  I will be more profitable in SF even buying at lower cap rates than Indy.  ", "replies": [{"id": "e0ch7f8", "text": "Okay, I figured out what the disconnect is!  I'm betting you're a broker or work in brokerage, since the what I am about to explain doesn't really affect your job.  You don't need to know this to do brokerage for Class A/B, and I have no idea what goes on in Class C.  You definitely understand how cap rates work, and I acknowledge that. What you are confusing is what \\*\\*yield\\*\\* is.\n\nFrom an investor's standpoint, there are a few yield metrics they look at, the most important being cash\\-on\\-cash return and the overall return\\-on\\-investment.  Regardless, these are percentages (usually higher than the cap rate, except during down markets where you also see terminal caps falling below overall caps) that estimate how much compounded return on an investment someone gets.  In Argus, this is underwritten as the Discount Rate.  When you get more returns for the same spending, you are getting higher yield.  In finance, there are various asset classes, but essentially the two main investment vehicles are stocks and bonds.  Real estate is an alternative to these:  the required yield in real estate is higher than bonds because there is a liquidity premium(not gonna bother explaining it, but just take my word for it, a bond will costs slightly more for the exact same yield as real estate because there is less liquidity risk.)  So bonds are safe, stocks are less safe, and real estate is essentially in between (obviously some CRE is safer than junk bonds, etc., but this holds true in general) stocks and bonds in terms of risk,  However, they ALL contain risk, except (at least the entire finance community assumes this though this is arguably not true) t\\-bills, whose yield are considered the \"risk\\-free rate.\"  Let's look at your example\n\n&gt;  the market is paying LESS for the CHANCE at the EXACT same POSSIBLE NOI.  \n\nThis is literally a definition for higher yield.\n\n&gt; There's no way you'd pay the same for $100,000 NOI IN SF as you would in INDY. You would assume higher rent increases and greater demand, easier turnover on the SF property. All you have to do is look and compare rent growth in the two cities. SF blows the doors off Indy. \n\nThis is part of why cap rates compress in a market.\n\nYes, lower cap rates are found in markets with higher rent growth, easier turnover, etc. that you noted.  That's why there is more RISK in Indy than in San Francisco that the underwritten assumptions(the main one being rent growth/lag time/TI's for the deal, etc.) will be met. \n\n&gt; I will be more profitable in SF even buying at lower cap rates than Indy. \n\nThere's a saying that all mutual funds are told to disclose that basically goes \"past performance is not indicative of future results.\"  Obviously, there's a belief that past performance will continue, and this is why people are willing to pay MORE for the SAME return.  So the answer is basically no, that's not the case.  The beauty of real estate though, is that every property is slightly different, and as such, their results are different. Not to mention cap rate compression is a huge part of the out\\-sized returns people got from SF assets over the past four years or so, but as I described earlier, Class A buildings will always have a higher yield to AAA bonds in general, that's how they're priced by the market.\n\nHope this makes it more clear!", "replies": [{"id": "e0cjg38", "text": "Sorry but I think you've muddled this mess even further for those that don't understand cap rates.  I appreciate the dialog but you are trying to speak for  me and I don't need you to.  I am an expert on real estate valuations and that includes cap rates.  \n\nI am in NO way discussing yields.  Had the OP mentioned increasing his yields I would NOT be involved in this thread.  Cap rates do not measure yields since they basically ignore appreciation and capex, a big part of the profit and expense of real estate.  \n\nIt is hard to compare real estate markets generally.  It is even harder to try to compare stocks and bonds to real estate.  Think about this, stocks sell for the same to every buyer in the United States.  Real estate sell at different cap rates in the hundreds of markets across the US.  In your analysis it would seem that an Indy property would be a better substitute for stocks than one in SF just because the market is ONLY willing to pay say half for the chance at the EXACT same NOI.  Generally the investors in that market are there ONLY because the barrier to entry is so much lower not that they think it is more profitable.  In fact BOTH markets cap rates reflect that knowledgeable investors think they can ONLY be profitable in INDY if they can pay half of what the exact same (possible) NOI is worth in SF.", "replies": [], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}, {"id": "e0c8l27", "text": "\"A cap rate merely measures the market demand for NOI.\"\n\nNo it doesn't.  \n\nDid you mean to say -  \"cap rates, on closed properties, in a particular market, are indicative of the that market's demand\" ?  Because that would be correct compared to what you said.\n\nI'm trying to drill down on how your are coming to your conclusion that cap rates are FAKE or not important.", "replies": [{"id": "e0cavs6", "text": "You HAVE to have a closed sale to have a cap rate comp just as you need a closed sale to have a sales comp.  Now you can guesstimate but why would you.  The going in rate is FAKE.  It is not measuring anything real.  A NOI used for cap rate calculation STARTS with PGI.  Here that is being completely ignored.  That and the lack of a closed comp makes it FAKE.", "replies": [], "depth": 7}, {"id": "e0my62c", "text": "Hey not sure how to send you a private message but I would like to respond to a post of yours.", "replies": [{"id": "e0n3gt1", "text": "Just click on my screen name and hit private message.\n", "replies": [], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}, {"id": "e0btaf3", "text": "Yield is the correct term in this context, even though some use \"cap rate\" interchangable for yield, it's technically incorrect.", "replies": [{"id": "e0c519h", "text": "100%. ", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "e0astdf", "text": "Good explanation!  Thanks.", "replies": [], "depth": 3}, {"id": "e0b9bvm", "text": "OK, going in cap rate.  Of what use is this number?", "replies": [{"id": "e0bcoil", "text": "It is what you paid for the asset. NOI/purchase price. Exit cap rate is NOI/sale price. ", "replies": [{"id": "e0bix3o", "text": "You paid $10M for the asset.  That other calculation is meaningless.", "replies": [{"id": "e0bq4pg", "text": "I would use going in cap rate vs. stabilized cap rate in only the conversation he described.  You can relate the information in a number of ways, but in this way you offer a clear and easy understanding of the value add component and the exit strategy while always keeping it in transactional terms.  Most value add investors aren't buy and hold types.", "replies": [{"id": "e0cc64m", "text": "\"Clear and  easy?'  Bought for 10 sold for 13! What is clearer and easier than that?  You've been taught incorrectly to muddle figgers so it makes you look more \"real estatey\" when a professional will be able to quickly identify you as a novice.\n", "replies": [{"id": "e0cfhoq", "text": "Sounds like you take offense to big words and confusing numbers.  I'd know that if we spoke and I was selling you a deal.  I imagine my pitch would be something akin to drawing some dollar signs with a marker and make big elaborate circles around them with arrows pointing to it.", "replies": [{"id": "e0cht00", "text": "In 6 fucking words I accomplished \"clear and easy\"!  Let's see you do the same instead of attacking me personally.  You couldn't sell me shit because I can easily tell you are not informed on the subject.", "replies": [{"id": "e0cinmu", "text": "Buy this, charge more, get paid.  Even /u/Honobob gets it!", "replies": [{"id": "e0ckbnp", "text": "NO, I want to know how much I'm getting paid and how much More than what I paid.  My six words states all that \"clear and easy\"  and your attempt has FAILED.  clear and easy my ass!  NO SALE for you!", "replies": [], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "e0bth1l", "text": "This is not correct.  You're increasing the YIELD, not the cap rate.  The cap rate is a function of what people are willing to pay for the asset in the market.  ", "replies": [], "depth": 3}, {"id": "e0cl9et", "text": "[https://www.reddit.com/user/froggy184](https://www.reddit.com/user/froggy184)   What's the PGI on the $10M sale and what is it on the $13M sale?", "replies": [{"id": "e0co5oa", "text": "Who knows?  Who cares? This is a notional deal and you are clearly an expert in real estate. I doubt I could add to your exceptional knowledge base. ", "replies": [{"id": "e0comcn", "text": "I was just going to use your example to illustrate a learning concept for those interested in cap rate usage.  ", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e0aeogj", "text": "I like the \u201cbuy at a higher cap rate\u201d advice. Easier said than done much of the time. ", "replies": [], "depth": 1}]