Does a higher CAP Rate always mean it’s a better investment? Correct me if I’m wrong but I feel like there’s a a lot of factors overlooked when deals are presented
I see people post deals and make it sound like the best investment in the world. But in investment deals, what do(es) the investor(s) NEED to know in order to make better judgement and decision..?
[{"id": "gwnnhb0", "text": "If everyone\u2019s advertisements seem like the best deal in the world, you will end up broke quite quickly.", "replies": [{"id": "gwnnsaa", "text": "Are you saying that people who see them as the \"best investment in the world\" are goi to end up broke because of their lack of due diligence? I was being sarcastic when I said that anyways lol. What I meant is the people who post them market them as such where you only see the tip of the iceberg.", "replies": [{"id": "gwno164", "text": "Find a broker to represent you, you have no idea what you\u2019re doing.", "replies": [{"id": "gwno7za", "text": "Lol I\u2019m not even in CRE yet. I\u2019m a lurker of this group and trying to better my knowledge. I\u2019m only 20.. ofc I don\u2019t know what I\u2019m doing. We all start somewhere!", "replies": [{"id": "gwnrw49", "text": "Fuck that other guy but alright here we go. Assuming you\u2019re buying a building?\nI think brokers tend to price things a bit high for negotiation. Check other local recent sales, use their prices for comps if in similar condition and use price per square foot to compare. The best thing I\u2019ve found to negotiate is the condition of the building itself. If you\u2019re buying a building always get a good set of environmental surveys done, if it\u2019s an older building structural engineers, check mechanicals, HVAC, plumbing, see for asbestos (HUGE issue, common &amp; expensive), the works. You\u2019d be amazed how much you can negotiated down a price even on \u201cas is\u201d buildings. Always check municipal zoning codes to make sure what your idea to use the building for is permitted. If you ever find yourself looking at a building that was sold recently and then relisted for twice the price?  Check to see when the building was sold before it via the municipal parcel search, if it seems like they bought it for much less than theyre selling it for then ask for some kind of capital expense report or profit and loss statement showing how much money they used to renovate it. Should usually sus out anyone just shooting for the moon with their price. Check to see if a building is in an opportunity zone for tax benefits. Commercial loans certainly differ as well, you\u2019re going to end up putting more down and it\u2019ll be due sooner to make it simple. Commercial loans aren\u2019t like residents 30 year loans. \n\nCOMPS or comparison sales are going to be the best way other brokers gauge how much things tend to go on market for. Sometimes that can devalue a property or make it more value depending on how much something sold for, if it went high or low. But ultimately a building is worth what someone will pay for it. I had a shit warehouse listed for 525k. The initial LOI came in at 400k. These two knuckle heads had a bidding war all way up to 570k even though that\u2019s not what it was worth at all. \n\nAssuming you\u2019re interested in brokerage? Start studying to get your license now. You can get it all online, it\u2019s easier than 2 credit online course and you\u2019ll breeze through it. During college/study whatever look for INTERNSHIPs are large-medium local brokerage firms and just see if they need someone to help organize papers and be a fly on the wall for deals. Graduate and use your newly passed real estate license exam to start interviewing brokers to hang your license with. You\u2019re interviewing then not the other way around. Commercial is harder to get into for sure. They say it takes 3 years to make a decent livings and you can expect to make 50 cold calls a day everyday for those 3 years.", "replies": [], "depth": 5}], "depth": 4}, {"id": "gwnow2q", "text": "Dude why be a dick? He posted to learn.\n\nI agree a broker is the way to go but you could at least provide some advice.\n\nOP, no cap rate is not everything but the cap you buy at is a helpful way to measure how well you bought a good deal. It can make a good deal great but there are a million other factors.\n\nNot to mention if something is listed at an abnormally high cap rate it\u2019s probably more of a red flag than a good sign. Buying at a high cap is usually going to be the product of good negotiation, knowing something the seller doesn\u2019t, or other factors.\n\nStart out by reading The Real Estate Game and speaking to people in industry.", "replies": [{"id": "gwnpoa7", "text": "Appreciate that! It\u2019s hard learning out here with hostile smart alec\u2019s", "replies": [], "depth": 5}, {"id": "gwnry1z", "text": "Fuck you take your real answer \ud83d\ude02", "replies": [{"id": "gwo1ji7", "text": "Appreciate both of them haha", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gwnogde", "text": "I think we can make a deal. Let's talk....", "replies": [], "depth": 1}, {"id": "gwnpmya", "text": "Just so you know - cap rate is typically a function of perceived stability of the asset in CRE.\n\n\nLow (4-6.5%) is perceived as very stable.\n\nMid (6.5-8.5) is considered acceptable risk and where most of the value add deals are\n\nHigh (8.5-20) are considered \u201chairy\u201d deals that need an investor to help clean them up and for that they pay out stupid returns.\n\nSo in essence if you\u2019re after your highest cash on cash return and don\u2019t mind the risk sure high cap rate deals are awesome...\n\nIf you\u2019re playing to make money long run and don\u2019t want that much risk go mid range.\n\nIf you\u2019re institutional (you\u2019re not but if you get there) you\u2019re wanting bond like stability with better rate of return stay low cap rate.\n\nEdit: as was pointed out below the cap rates above are reflective of my market. You will need to evaluate your own market and look at what it\u2019s breakdown is.", "replies": [{"id": "gwnu5r6", "text": "Just so you know - cap rate is typically a function of perceived stability of the asset in CRE.\n\nTHIS.  This is the thing that so many people lose in translation or don't understand.  It's an objective metric of subjective confidence in (a market or a particular asset.)  It's not a way to say that something is better than another, it's a way to measure risk and to fit an asset into your portfolio.  \n\n I once gave a presentation to a very smart group of REIs and most of them still couldn't get the objectives out of their heads.  They wanted me to say, (for example) \"biotech caps are better than retail,\" and I wouldn't-- I couldn't.   At least not in good conscience.   We all left the room feeling like it was all a waste of time.   \n\nSo no-- you still need to chase the deal YOU want based on YOUR  return and YOUR confidence in the market or asset in question.", "replies": [{"id": "gwnvgv6", "text": "Thanks! - I\u2019m a developer and CCIM candidate so I appreciate the validation :)", "replies": [{"id": "gwnxrnf", "text": "Ditto.  I may be doing CCIM after I finish my MRED.", "replies": [], "depth": 4}, {"id": "gwodc6z", "text": "Thank you so much!! Btw, what is CCIM in simple terms? I think it\u2019s a certificate but what\u2019re the qualifications to attain it and benefits?", "replies": [{"id": "gwofprl", "text": "C.C.I.M. - Certified Commercial Investment Member. It\u2019s an independent organization that provides education, resources, and networking for CRE professionals. Think of it as a Masters in Real Estate, but more geared to investors/brokers rather than say property managers.  \n\nhttps://www.ccim.com/about-ccim/what-is-a-ccim/", "replies": [{"id": "gwqaonp", "text": "CCIM is a great curriculum. Highly recommended.", "replies": [], "depth": 6}], "depth": 5}, {"id": "gwqmz1b", "text": "It\u2019s a professional designation. Check the CCIM website for exact requirements.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "gwp5y9g", "text": "I wish you would print this up and give it away free to anyone who is just getting started in CRE and is confused about cap-rate and what it measures. Your explanation is short, to the point and truthful. Thank you for posting.", "replies": [{"id": "gwqkk2m", "text": "Welcome - glad you found it useful", "replies": [], "depth": 4}], "depth": 3}, {"id": "gwp7pv1", "text": "I'd clarify this by saying it's only an objective metric if it is an as-is cap rate using actual financials. Many brokers will market deals using cap rates based on pro forma financials.", "replies": [{"id": "gwpiycb", "text": "Agreed.  Sales comp rates OR your own entry point.  Agreed wholeheartedly.", "replies": [], "depth": 4}, {"id": "gwqmg29", "text": "&gt;I'd clarify this by saying it's only an objective metric if it is an as-is cap rate using actual financials. Many brokers will market deals using cap rates based on pro forma financials.\n\nThere is no such thing as \"as is\" cap rate.  You are mistaking that with \"as is\" NOI.  You want to know what NOI the property is capable of producing.  If it can produce a NOI of $100,000 in a 5% cap rate market then it would be worth $2,000,000 less the lost rents and lease up costs and the negotiated risk of getting it there.", "replies": [{"id": "gwqommp", "text": "I'm not mistaking that. I figured it was implied to anyone who's been in the industry that I mean the cap rate associated with an as-is NOI and the list price.", "replies": [{"id": "gwsxbwf", "text": "So then you could calculate an \"as is\" value on a brand new vacant office building.  I challenge you to show the math and the resulting value.", "replies": [{"id": "gwt32jd", "text": "Did you read my original post? Any time you are calculating any statistic based on as-stabilized or pro forma financials you are introducing an element of subjectivity and the statistic ceases to be an objective metric.", "replies": [{"id": "gwt3u43", "text": "K, so you are saying you cannot value a vacant office building using direct capitalization?  I can.", "replies": [], "depth": 8}], "depth": 7}], "depth": 6}, {"id": "gwtlcpl", "text": "&gt; I mean the cap rate associated with an as-is NOI and the list price.\n\nOf what use would that be to anyone?", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "gwo4zdf", "text": "The only thing I\u2019d add here is that comparing cap rates is only useful in a vacuum in the sense that it has to be across similar assets, markets and profiles. In other words \u201call else being equal\u201d it *might* provide some insight as to what deal is \u201cbetter\u201d than another. But like anything the devil is in the details and how one deal calculates NOI vs another etc. As others have stated cap rates are just one of many variables to consider.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gwnqcf3", "text": "Are junk bonds always better then government bonds? The yield is higher! \n\nAnd depends on the investor, what the rest of their portfolio is and long term goals are. \n\nSometimes cap rate is negative but it still makes sense to people.", "replies": [{"id": "gwpj0wf", "text": "&gt;Sometimes cap rate is negative but it still makes sense to people.\n\n**THERE IS NO SUCH THING AS A NEGATIVE CAP RATE.**", "replies": [{"id": "gwpjse8", "text": "Ok boss, what the fuck is it called if you kick in money for each mortgage payment.", "replies": [{"id": "gwpof2a", "text": "Cap rate is NOI capitalized. Before debt service, so by definition no you cannot have a negative cap rate.", "replies": [{"id": "gwpre2h", "text": "Actually, you can indeed have a negative CAP rate, and I saw my first one the other day.  Close by in Hermosa Beach, California - fully rented and occupied.  The rental income was not high enough to cover the costs to operate the property (most specifically, the real estate taxes).  So, the NOI was negative, and thus the CAP rate was negative.  Rare, unusual, and generally stupid, but it does exist.", "replies": [{"id": "gwpruba", "text": "Personally, I would consider that a \"negative cash flowing asset\" or similar. Probably for tax purposes. Insofar as cap rate used to derive value its not possible or seller would be paying you.", "replies": [{"id": "gwqiqg6", "text": "Scammers have these novices convinced that \"cash flow\" is profit.  Sad that when it is shown to not be true they strike out against those trying to educate them instead of the scammers that are lying to them.", "replies": [], "depth": 7}], "depth": 6}, {"id": "gwq8pw9", "text": "I'd love to see the math for the impossible.  Let's start with calculating NOI.  You were taught incorrectly.", "replies": [{"id": "gwqur6j", "text": "**Can any downvoter provide the calculation for negative cap rate or are you all just scammers?**", "replies": [{"id": "gx7bzdy", "text": "Negative cap rate doesnt exist. If NOI is less than zero the cap rate on an asset purchase would be reported as 0. Cap rate is completely meaningless though in this context, you would be basing valuation on the NPV of future cash flows discounted by a DR reflective of the risk associated with stabilizing the asset.", "replies": [], "depth": 8}], "depth": 7}], "depth": 6}, {"id": "gwqce4o", "text": "What was the PGI ? Do yo even know what that is?  Can you show the calculations to get a \"negative\" NOI ?", "replies": [], "depth": 6}, {"id": "gwqflhb", "text": "This is a funny discussion - it reminds me of the old \"less filling, tastes great\" commercials for Miller Lite.  \n\n\nJust to make sure I wasn't crazy, I looked up the definition of CAP rate:   \n[https://www.investopedia.com/terms/c/capitalizationrate.asp](https://www.investopedia.com/terms/c/capitalizationrate.asp)\n\nBasically, NOI divided by Market Value.  Just to make sure I wasn't doubly crazy, I looked up the definition of NOI:  \n[https://www.investopedia.com/terms/n/noi.asp](https://www.investopedia.com/terms/n/noi.asp)  \n\n\nNet Operating Income = Rental Revenue - Operating Expenses\n\nSo, if the rental revenue is less than the operating expenses, then the NOI is negative.  A negative NOI by definition would result in a negative CAP rate.  Everyone said similar things a few years ago when they said \"bonds cannot have a negative rate of return\", but some of those bonds (in Europe) actually do now!\n\nI've only seen one property where the revenue couldn't cover the actual operating expenses of the property - here in SoCal.  The people are betting on the appreciation of beach front property, for sure.  With the case of this particular property, the rental income was less than the property tax expense.", "replies": [{"id": "gwqiiyz", "text": "Nope, the investopedia definition is 100% incorrect.  Again, step up and show the calculation for a negative cap rate.  You cannot.  Like Sasquatch, you can claim to see it but you have no proof!", "replies": [], "depth": 7}, {"id": "gwrllwr", "text": "&gt;So, the NOI was negative, and thus the CAP rate was negative.  Rare, unusual, and generally stupid, but it does exist.\n\nNope, it seems you don't know how to calculate NOI.  Under your premise even a brand new vacant property would be worth zero.  See how foolish that sounds?", "replies": [], "depth": 7}], "depth": 6}, {"id": "gwt03um", "text": "u/heatfar808 \n\nSince the formula is V=i/r  Please show the calculated value of this mythical property.  Even better provide a link to the property.  I think someone may owe me a beachside property and some cash!  LOL", "replies": [{"id": "gx2krf9", "text": "u/HeatFar808\n\n&amp;#x200B;\n\nCrickets?   LOL", "replies": [], "depth": 7}], "depth": 6}, {"id": "if2jlvz", "text": "Would you adjust for the deductibility of the taxes in your calc?  Would that bring it positive?", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "gwqc1de", "text": "Is this a real question asked in a commercial real estate forum?  So you know what PGI is?  Sir, you have been scammed and you want to take it out on someone that is trying to educate you?  Geez!", "replies": [{"id": "gwtfd7m", "text": "Not sure if trolling or not, but mission accomplished. I am very annoyed by you.", "replies": [{"id": "gwukcg7", "text": "Just because you can't answer any of the questions or do any of the math?  Geez, can't say I'm sorry for your decision to be ignorant.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gwnr30j", "text": "Quick response: No, it most certainly does not.  There are a few concepts/fundamentals that people often gloss over or just outright ignore when speaking about RE investments.  Cap rate is just NOI/Value.  When people get excited about high cap rate it is because they are \"buying\" a lot of NOI for relatively small amount of \"value\"...or a \"cheap price\".  \n\nBut this ignores many things.  Fundamentally - risk.  There is \"no such thing as a free lunch\".  If a building is cheap, it is very likely due to higher risk.  This is why cap rates are correlated w/ the \"class\" of a building.  A stabalized, 100,000 sf office property in a Tier 1 city will \"trade\" (just means sell or transact) at a 4 cap...but a rundown crappy 10,000 sf office in a Tier 2 city will \"trade\" at a 5 cap.  Lots of reasons why (availability of capital and supply/demand of investors) but also because it HAS to.  A crappier building has to be relatively cheaper.\n\nNote that cap rates are simplified and you should be clear on what the numerator and denominator is...is that value account for all the capital required? is the NOI proforma? any recurring capital missing.  Etc.\n\nHere is an old CBRE cap rate survey.  You can see how CRE thinks/lists/quotes cap rates for various property types, classes, and locations: [https://www.cbre.us/research-and-reports/US-Cap-Rate-Survey-Special-Report-2020](https://www.cbre.us/research-and-reports/US-Cap-Rate-Survey-Special-Report-2020)\n\n&amp;#x200B;\n\nHere is a brief write up on the matter I did.  Maybe some useful gems: [https://www.moneyweighted.com/conceptualizing-cap-rates/](https://www.moneyweighted.com/conceptualizing-cap-rates/)\n\n&amp;#x200B;\n\nLastly, note that (direct) cap rate methodology for valuation is great (as evidenced by its prevalence and use by appraisers) but depending upon the need and where you are at w/ the analysis... more sophisticated cash flow modeling is usually done.\n\nJust my two cents.  Hopefully some of it is useful.  Best!", "replies": [{"id": "gwosq2i", "text": "Excellent links.", "replies": [], "depth": 2}, {"id": "gwovlnx", "text": "Your write-up is a great intro on these topics! Good work", "replies": [{"id": "gwoxhb5", "text": "Thanks a lot! Just trying to add value any way I can.", "replies": [{"id": "gwp29pn", "text": "You definitely did", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gwnsd87", "text": "Cap rate is often times a direct indicator of the level of risk associated with the investment.  You need to analyze exactly what places that cap where it\u2019s at.  Often times as you learn asset types you can predict why. Leases expiring, condition, limited future use, low demand property type, etc.", "replies": [], "depth": 1}, {"id": "gwo3agy", "text": "It\u2019s definitely not cut and dry. You\u2019ll always hear sell low, buy high. However, it\u2019s more intricate than that. A cap rate can be easily adjusted by altering the sales price. I look at it as a just a jumping off point. Some investors insist on a certain cap rate and won\u2019t consider properties marketed outside of their range. However, there are many factors to consider. 50k view, comp, income, market, etc. all play a roll. \n\nSo, I think you\u2019re on the right track as far as your thinking. It\u2019s certainly not the end all, be all of Investments. It\u2019s our job to educate our clients and help them make educated decisions. \n\nHope that helps a little bit, and good luck to you when you enter the CRE world.", "replies": [], "depth": 1}, {"id": "gwo7fus", "text": "Cap rate is good. How long and consistent landlord can collect the high rent?", "replies": [], "depth": 1}, {"id": "gwo8jev", "text": "Easiest, simplest explanation:  Higher risk, higher rate.\n\nYou can (theoretically) buy a McDonald's building leased to a franchisee with a 20 year lease.  You basically have a guarantee, that income will be there for 20 years.  Even if they decide to tear down the building, you will still collect rent.  Incredibly low risk.  \n\nWhere does the cap rate go?  Investors will compete hard for it.  They bid the price up, that means the corresponding cap rate goes down.\n\n18 years later, it's a different story.  2 years left on the lease.  They are not obligated to stay.  The guaranteed income term is short.  There is more risk.  There is more speculation involved.  Investors will still compete, but there's more likelihood that the property will need more investor input, securing an option to extend the lease, spending more money to keep the tenant, or getting a new tenant, who will probably want a different building.  Risk goes up, rate goes up, price goes down.  Tougher, also, for you to get a loan, as the bank will want to know what your plans are for the end of the lease.\n\nLook at other deals similarly.  Local tenant, mom and pop restaurant?  There is no way they can guarantee to pay the rent the same way McDonald's can.  Shorter lease, tenant with worse credit, higher risk, higher cap rate.\n\n McDonald's might be like a 5% cap rate or less.  Is that enough return for your needs?  McDonald's late in the lease means you pay less for the same income, and your return for a couple years might be 7%, with a prospect of a higher rent later, but also the prospect of down time with no income, or spending money to attract and build out for a new tenant.  Does that work for you?  The mom and pop, maybe you're looking at a 9% cap rate, and they sign a five year lease, and you look at their business plan and think they could become really popular and stay in that location a long time, but they might go belly up, as many do.  Is that what you're looking for?  So, what's better?  The answer, as always, is that \"better\" means different things to different investors.", "replies": [{"id": "gwod3jl", "text": "That makes a lot of sense. Many factors to look into beyond the property in itself too. On a side note- I heard McDonald\u2019s owns all their buildings and lease it out to franchisees(I know you were just using it as an example).\n\nThank you so much. Really good insight on measuring risk.. which we gotta take a lot of in this industry, it seems!", "replies": [{"id": "gwpiikt", "text": "&gt; On a side note- I heard McDonald\u2019s owns all their buildings and lease it out to franchisees(I know you were just using it as an example).\n\nNo, I appraise McDonald's ground leases and NNN leases for sale and financing all the time.  I used it because it was on my mind for a job I'm working on.  The reason I said theoretically was that there are a lot of financing and corporate hoops you have to jump through.  But it can be done.", "replies": [{"id": "gwq24l9", "text": "They typically own the building in ground lease structure. Then they just pay rent to the owner of the dirt. So usually it\u2019s a franchisee who signs a lease with McDonald corporate on the building, and then McDonald\u2019s corporate signs the ground lease with a regular investor on the dirt. \n\nSource: sold many McDonald\u2019s.", "replies": [{"id": "gwq2be4", "text": "Yes, that's correct, sorry I was unclear.  Even in a NNN situation where the Leased Fee owner owns the building, McDonald's and most Quick Serve Restaurants reserve the right to demolish the improvements if they are replaced with an equivalent structure.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gwondpm", "text": "CAP rate is a ratio and a basically a number that you can use to compare and contrast two similar type of commercial properties in a similar kind of market. So you have to put it in a context. Fully occupied properties at low cap are considered stable while higher cap rates are considered risky in general. A good multi tenant fully shopping center at under 7% cap approx. is considered class A and stable. A multi family at 7% cap is probably under med-high risk category. You have to look at apples to apples when using cap rates.", "replies": [{"id": "gwql8em", "text": "&gt;CAP rate is a ratio and a basically a number that you can use to compare and contrast two similar type of commercial properties in a similar kind of market. So you have to put it in a context. Fully occupied properties at low cap are considered stable while higher cap rates are considered risky in general.\n\nAll similar properties in the same market will trade in the cap rate that the market supports.  If properties are trading at an 8% cap rate then similar properties will trade at trade in that range.  No property has a cap rate until it sells because the cap rate measures what the buyer was willing to give and the seller was willing to take.  \n\nLow occupancy or stabilized properties will sell at the same cap rate.  The difference will be in the sales price adjusted below the line.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gwos2jt", "text": "A higher cap rate means the investor (or the seller) deems the asset to be valued *less* than an investment with a lower cap rate.\n\nBy virtue, it may indicate urgency on the part of the seller, or \"opportunity\" (or lack of faith in the asset) by the buyer.\n\nBy itself, the rate only signifies the value placed on the asset by the seller or the buyer.  The rate implies a variety of other things (safety, trust, quality), but it only \"means\" one thing:  Value.", "replies": [], "depth": 1}, {"id": "gwoywix", "text": "I don\u2019t think that is the right way to think about it. CAP rate is a function of risk, so higher cap isn\u2019t necessarily a better \u2018deal\u2019 / it is a riskier asset. The questions are: what knowledge do you have relating to the risk you are taking on and what is your comfort level with that risk.\n\nA great example of this concept is if you look at the sale of cannabis dispensaries in states where they are legal. Typically a very high cap rate compared to similar leased assets. Why? Because the rent is usually above market &amp; if the existing tenant goes out of business or get shut down or the laws change, it is very unlikely you will find another retailer willing to pay the same rent. So, a 12% cap dispensary could be a \u201cbetter deal\u201d than a 5% Cap BofA branch, but risk associated is much higher for the federally illegal business (for the time being anyway ) than for the bank. Additionally, you will have a much harder time getting a loan for the cannabis shop vs the bank.", "replies": [], "depth": 1}, {"id": "gwpa4qc", "text": "What is the cap rate is 2% and the price per square foot is 20.00 per sq.ft? Cap rate isn\u2019t indicative of \u201cgood deal vs. bad deal\u201d it\u2019s just one data point.", "replies": [], "depth": 1}, {"id": "gwpdsk2", "text": "In a perfect market the cap rate would represent the risk directly. What makes things interesting is that different risk means different things to different investors. Some people are more sensitive to turnover risk, others default risk, others capex.", "replies": [], "depth": 1}, {"id": "gwpi4zr", "text": "**CAP RATES MEASURE VALUE.**  Cap rates come from an income approach to value called direct capitalization.  In a 10% cap rate market investor have paid $10 for each possible dollar of NOI and in a 5% cap rate market they have paid $20.  How simple is that?  the formula is V=i/r  The V is the value you are trying to determine.  The i is the NOI the property is CAPABLE of generating if operating to market.  The r comes from analyzed closed sales of similar properties.", "replies": [], "depth": 1}, {"id": "gwpip68", "text": "**CAP RATES DO NOT MEASURE RISK**  Although cap rates can be indicative of risk they do not measure risk.  A Class A CBD office in Philly trades at 7% last i looked.  In SF that same Class A CBD office would trade at a 4% cap rate.  You cannot say that Philly is almost twice as risky as SF.  they probably have the same national tenants.  The 3% difference is not a measure of the risk but more likely reflects the difference in rents per sf since a larger part of that NOI will be needed to cover capex down the road.", "replies": [], "depth": 1}, {"id": "gwpkr76", "text": "**CAP RATES ARE NOT A \"RETURN\" METRIC.**  Scammers want novices to believe a cap rate is a \"return\".  They buy at 14% cap rate (V=i/r $7.14=$1/14%)  and sell to you at a 10% cap rate ($10=$1/10%)  They are making $2.86 off every dollar of NOI they sell you.  Hmmm\n\nYou will see most of the Youtube scammers claim that a cap rate is the unleveraged \"return\"!!!  Total scammer talk.  If a cap rate was a return then explain why the seller of $100,000 NOI in Podunk can only get $1,000,000 in a 10% cap rate market but the CA seller can get $2,000,000 (5% cap rate) for the same $100,000 NOI.  Why sell TWICE the \"return\" at half the price.  LOL", "replies": [{"id": "gwpnifa", "text": "Why\u2019re you so quick to call people scammers?", "replies": [{"id": "gwprywl", "text": "Quick or slow don't you think the sooner someone knows they are dealing with a scammer the better?", "replies": [], "depth": 3}, {"id": "gwu3fpk", "text": "&amp;#x200B;\n\nWhy are you so gullible to believe people that can't back up their claims with basic math?  You are primed to be scammed.", "replies": [{"id": "gwu9nc1", "text": "I\u2019m not. I\u2019m just asking a simple question and it clearly offended you haha but I appreciate the info!", "replies": [{"id": "gwua7mk", "text": "Not offended at all by your question.  What is offensive is all there Brohards trying to scam you and you seem more concerned about the scammers feelings than the person giving you correct answers to your question and warning you about all the incorrect information you have received.  But that is how scammers work.", "replies": [{"id": "gwuc7oz", "text": "Yeah it\u2019s hard with all the misinformation. But also my question was vague and everybody has different situations as well as preferences", "replies": [{"id": "gwue939", "text": "Different situations and preferences does not change the definition of cap rates.  That is what a scammer will tell you when you try to call them out.  Cap rates measure what investors pay for NOI. period.  V=i/r  Now if you are a parole officer and your wife is a police officer in Detroit you can probably do well investing in 15% cap rate properties.  The normal investor,  not so much.  \n\nCap rates do not measure returns so it is up the the investor to determine why in one market $1of NOI  sells for $10 and in another $20!  Some of that MAY be risk but cap rates do not measure risk.  It may be profitability but cap rates do not measure profitability.  Just as there are properties that sell for $100 a sf or $1,000 a sf you cannot tell which property will be more profitable because like a cap rate it is just a value measurement.\n\nAND, there is no such thing as a 0 or negative cap rate.", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "gwptk4u", "text": "Sorry, I disagree with your assessment, and I will answer your question (as someone who owns buildings in both CA and \"Podunk\" too! :) ).  It does go down to a perceived measure of risk.  There is a risk that the \"Podunk\" property will be vacant in the future for an extended period of time, whereas the CA building (in presumably booming CA) would not be as vacant in the future.  If the California \"economy\" starts to decline and the vacancy rates start to rise, then we will certainly see an expansion (rise) in CAP rates.\n\nThere are also indirect intangibles, like how good the improvements are - how much Tenant Improvements (TIs) will be needed if a particular Tenant leaves?  Or, in \"Podunk\", there is typically lots of free land available to build new construction (not the case in Los Angeles for sure).  The availability of vacant land definitely places a ceiling on CAP rates in \"Podunk\" areas.  A potential tenant can always choose to build new construction instead of leasing out an existing property.  Such options absolutely do not exist in some areas of California (Los Angeles).\n\nWhere some might see some weirdness or disconnects are in the \"Podunk\" areas of California.  Areas that are way out of the way of any major cities, where there still is plenty of land, etc.  These are the areas that make me scratch my head and wonder \"who's buying this stuff?\"  Indeed, the way to make money in Commercial Real Estate (or any investment for that matter) is to analyze the risk and determine the areas where the market is overestimating the risk, and avoid areas where the market is underestimating risk.", "replies": [{"id": "gwq9foh", "text": "&gt;Although cap rates can be indicative of risk they do not measure risk.  A Class A CBD office in Philly trades at 7% last i looked.  In SF that same Class A CBD office would trade at a 4% cap rate.  You cannot say that Philly is almost twice as risky as SF.  they probably have the same national tenants.  The 3% difference is not a measure of the risk but more likely reflects the difference in rents per sf since a larger part of that NOI will be needed to cover capex down the road.\n\nSee, cap rates were designed to value NOI.  Although risk is part of the valuation determination you cannot say the 3% difference is all risk when in fact it may not even be any part of it.", "replies": [], "depth": 3}], "depth": 2}, {"id": "gws3wmg", "text": "&gt;w what NOI the property is capable of producing.  If it can produce a NOI of $100,000 in a 5% cap rate market then it would be worth $2,000,000 less the lost rents and lease up costs and the negotiated risk of getting it there.\n\nu/Honobob is totally correct. Although the going-in (or Y1) CAP rate may be an indicator of asset or market risk it's just a measure of value for a point-in-time.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gwpwpiy", "text": "I recently saw a retail unit in downtown Palo Alto going for 1.4% cap rate. Was the lowest I'd ever seen. Seems like that's just a case of betting on pure appreciation at that rate...", "replies": [], "depth": 1}, {"id": "gwqmcs5", "text": "There are some good explanations on here, but there are a couple issues here to expand on First, the higher the CAP, typically the higher the risk. While  u/Daytonaman675 gave a really good explanation, his CAP rates are not reflective of my market here in California...or of deals I am seeing here in the West (CA, NV, AZ, OR, WA). Truth being told, the only deals I have seen over the past couple of years greater than a 7% CAP deal were Dollar Generals or marijuana deals (keep in mind, marijuana is still illegal per the Fed government regardless of what your State laws are). Here in CA, I am seeing many deals in the 3% to 5% range and many of these are NOT taking into consideration the \"risk\" of the tenant. We have an eviction moratorium in Los Angeles County and now we have \"state rent control\" (for 2+ multi-family units)...and people are still buying these assets in the 3%-6% range (6% is out in the Inland Empire). My guess is many are relying on these assets to appreciate more than the CAP rate at the time they are acquiring these properties.\n\n&amp;#x200B;\n\nExamples of higher CAP rate deals. Right now there is a Best Buy property in Orange County, CA available at an 8.25% CAP. They have 2 years left on the Lease and it is unknown if they will be renewing. Asking price is +/- $23MM. The building is +/- 43,000 SF.  That's $535/SF for a building that more than likely will be empty in a couple of years. So yes, there are many other factors that need to be looked at other than the CAP rate.", "replies": [{"id": "gwqmy4m", "text": "I completely agree mine were geared towards Midwest MSA\u2019s.\n\nEditing to reflect that now.\n\nCA is some wild shit where if you get anything built it\u2019s worth A LOT", "replies": [], "depth": 2}, {"id": "gwqpiq1", "text": "Interesting. I plan on doing business in OR &amp; WA", "replies": [], "depth": 2}], "depth": 1}, {"id": "gwqr6d5", "text": "The market cap rate is the return measured against the risk. And based on your priorities, you might strongly prefer investments rated at 5% when 12% are otherwise available.", "replies": [], "depth": 1}, {"id": "gwrvqm3", "text": "Higher the cap rate generally means the more risky the investment is.  High risk high reward.  Lower cap rates are the opposite.\n\nNow the definition of risk is generally personal to the investment group and the definition of low verse high is also personal to the group.  \n\nMy company doesnt look at anything below a 7cap right now but it all shifts as the economy and area changes along with the tenant.\n\nEvery deal is different and needs to be examined on an island basis.  Plus the numbers need to be run every time to confirm.  The way brokers are listing things these days the cap rate is plainly just wrong and usually not in the buyers favor.  \n\nDo your own due diligence and homework and derive your own cap rate based on the numbers you see.", "replies": [], "depth": 1}, {"id": "gwshxni", "text": "Cap rates are meant to represent the perceived risk and stability of an investment. For this reason, cap rates at the low end of the spectrum (6.5% or lower these days, aka, near-zero risk) are fairly consistent and good measures of local value while high-risk cap rates (9 plus) vary wildly and are usually the result of owner or seller business dealings and not the market average. \n\nSo to answer your question, above a 9 cap there are many unrecognizable risk-reward variables that impact these pricing comps. As a simple ratio, cap rates are therefore less reliable measures of investment quality. \n\nAt the other end of the spectrum, cap rates are more reliable measures of investment excellence. The cause of variations in low-risk cap rates are typically the \"superbness\" of lease terms and perceived value for appreciation (and I find not much else).\n\nSuperb lease terms include the type of rent escalations, tenant credit (A vs A++), tenant responsibilities (Absolute NNN vs NNN with some carve-outs), indemnity agreements, among others.\n\nPerceived value for appreciation can be broken into tenant-tangible and market-intangible.\n\nTenant tangible examples include \"did the tenant just invest a big chunk of money into a capital expenditure at the property\", \"has the tenant occupied this building for multiple leases and is likely to renew at the end of the lease term\", and \"does this location represent a unique part of the tenant's business such as a leading sales generate or a local headquarters\".\n\nMarket-intangible appreciation is simply \"is this market hot right now and are rents anticipated to go up significantly over the next ten years\". This is a bit of a gamble. I find that past performance in rent increase is not a qualifier for future performance. But if a market is hot, no matter what you feel, cap rates will be suppressed.", "replies": [], "depth": 1}, {"id": "gwvbp8b", "text": "A cap rate is derived from the concept of perpetual bonds: the owner of the bond pays a certain amount money upfront for the bond and subsequently receives cash flow, in the form of an interest payment, for as long as they own the bond. The yield of the bond is cash that returns to the investor (as a percentage) in the form of interest.\n\nThe formula to calculate the yield is: Current Yield = Annual Interest Paid / Market Price of Bond\n\nThe general formula for a cap rate is *Cap Rate = Annual NOI / Value of Real Estate. *Note that for this formula to work for real estate, we need to put cash aside every year to extend the life of the asset. Here, the industry assumes CAPEX is equal to depreciation, offsetting above the line and below the line expenses.\n\nA cap rate is essentially a perpetual bond formula for the real estate industry. It's important to note there are couple different types of cap rates out and each has its own specific use.\n\nReported Cap Rate = Cap Rate Reported by Seller/Buyer/other party to transaction. When looking at comparable properties, this can help guide estimated value of the property using the Income Comparison Approach.\n\nEstimated Going-in Cap Rate = Yr 1 NOI, under your ownership/ Purchase Price. This helps establish a baseline when looking at your terminal cap rate during underwriting.\n\nTerminal Cap Rate = Terminal NOI (first yr of NOI after your ownership / expected sales price). The Terminal Cap Rate is used to estimate the resale value of the property beyond the projection period in a discounted cash flow model.\n\n\nOne follow up on cap rates.\n\nA cap rate, similar to yield, is the markets signal of implied risk.\n\nExample: Apples S&amp;P credit rating is AA+ and yields a ~2.64% whereas Netflix\u2019s credit rating is B+ \u201cjunk\u201d and yields ~6.4%.\n\nSimilarly Class A infill apartments in the US trade at 4.65% cap rates vs Class C suburban apartments trade at 6.24% cap rates (per CBRE\u2019s 2018 2nd half cap rate survey).\n\nSay that you have 2 apartment buildings that both generate 100,000 in NOI. One is Class A Infill and the other is Class C suburban.\n\nClass A Infill: 100,000/4.65% = $2.15M value\n\nClass C Suburban: 100,000/ 6.24% = $1.60M value\n\nWhile the properties generate the same amount of NOI, investors are willing to take a lower yield because the implied risk is less in a Class A infill location vs a Class C suburban location. In other words, the Class A Infill apartment\u2019s 1.59% lower cap rate creates 550,000 more in value than the Class C suburban apartment \u2014 all because investors feel more confident of future NOI.\n\nThat said, by understanding what cap rates are of comparable properties in the market, you can quickly see if the deal you\u2019re underwriting is generating similar yields to the market. If there is a disconnect, your job is to tease out what is causing the discrepancy (ex below market rents, below market expenses, deferred maintenance, etc) and take that into consideration in your underwriting.\n\nThe next step would be to evaluate whether you feel that cap rate on your investment will move during your hold. To compress cap rates, you can evaluate whether it makes sense to do value add work to convert it to a nicer product and raise rents, assuming there is demand. Additionally cap rates can compress as a neighborhood begins to gentrify as more investment is flowing into the neighborhood and investors are comfortable with a lower yield. The latter is very hard to determine and is never taken into consideration in our terminal cap rate.\n\nTLDR: Cap rate = Implied Risk", "replies": [{"id": "gwve543", "text": "&gt;TLDR: Cap rate = Implied Risk\n\nNah, cap rate = price paid for NOI.", "replies": [], "depth": 2}, {"id": "h5u0vgn", "text": "&gt;Estimated Going-in Cap Rate = Yr 1 NOI, under your ownership/ Purchase Price. This helps establish a baseline when looking at your terminal cap rate during underwriting.\n\nHow on earth would you arrive at a purchase price?  There is no such thing as a going in cap rate.  You are confusing that with the going in NOI.  That is real.  The rest is just to scam you.", "replies": [{"id": "h63f9ih", "text": "Last time I checked a purchase price is negotiated between a buyer and seller. \n\n\nA going jn cap rate gives you an indication of what yield you\u2019re getting during the first year of ownership based on the purchase price (actual, implied based on the market cap rate, or asking price).\n\nThis helps you understand 1) whether you\u2019re over / under paying based on the market 2) what yield you\u2019re getting taking into consideration your business plan (ex: change in income or expenses) and 3) whether you\u2019re underwriting a change in cap rate from acquisition to disposition.\n\nTldr: its a baseline for comparison.", "replies": [{"id": "h63n6ax", "text": "NOPE.  I agree that a cap rate leads you to a market value based on what other investors are paying for NOI but you have to analyze what the \"purchase\" price is buying.  How would you determine what to pay for an under performing property?  there are no \"going in \" cap rate comps for 50% occupied properties!", "replies": [{"id": "h64aqfn", "text": "&gt; yze what the \"purchase\" price is buyi\n\nExactly - which is why you would want to look at proforma. See example attached. By layering these 3 different cap rates (2019 Actual / Asking Price, Market Cap Rates, Going in Cap Rate) you can HELP determine whether you are getting an appropriate yield. In the example attached based on the proforma you are buying a property at a 6.75% yield whereas the market is at 5%. This means that there is room to create value (i.e. cap rate compression).\n\nThere is no \"silver bullet\" to determining value (finance is an art and a science). This method is considered a back of the envelope approach to determine whether you should dig deeper and do a complete underwriting.\n\n  \n\n[Example!] (https://imgur.com/7MurJKy)", "replies": [{"id": "h64ptp1", "text": "NOPE!  I am not writing off $750,000 of value based on some fake cap rate when all you have to do is put a \"for lease\" sign in the window.  Now if my property is worth $1,000,000 on a pro forma basis then  that is what I will sell it to you WITH below the line adjustments for lost rents and lease up expenses and a risk factor.  That could only be $100,000.  so you pay $900,000 not $250,000!!!!", "replies": [{"id": "h66p7dg", "text": "&gt;  off $750,000 of v\n\nOk so you're now acting as the seller? Which one is it? \n\nWe're trying to share our knowledge of real estate finance from an academic/institutional perspective. While I'm always up for a debate, it appears you don't have a strong grasp of financial concepts, let alone CRE financial concepts, to make a cohesive argument.", "replies": [{"id": "h66pt3g", "text": "Which don't you understand?  Is it below the line adjustments or capitalization of NOI?  I'm here to walk you through.  Just let me know because I am an expert on this subject.\n\nCap rates come from analyzed closed sales.  Any other is just a crap rate.  You can divide any number by another but that does not make it meaningful.  The value of a cap rate from an analyzed closed sale is that it tells you what actual buyers and sellers are doing.", "replies": [{"id": "h66taqq", "text": "&gt; nalyzed closed sales\n\nYou're mixing a couple concepts here 1) reported cap rate 2) going in cap rate and 2) levered/unlevered discounted cash flow (which utilizes a terminal cap rate to determine terminal value at t+1). \n\nThe beauty about cap rates is it's simplicity (i.e. what is the value of NOI today in perpetuity based on a certain yield). However, as of recently I've been seeing it used as an advertising gimmick to lure noob investors. If one doesn't know how it works from a theoretical perspective, its impossible properly to apply, analyze, and utilize it as a measuring stick out in the real world.", "replies": [{"id": "h66up55", "text": "NOPE!  There is only one cap rate and that is the cap rate at which investors are paying for NOI today as evidenced by cap rate comps.\n\nThere is no such thing as \"going in\" cap rate.  You are confusing that with going in NOI.  If you try to calculate a cap rate on two properties based on actual NOI but one building is 50% unoccupied you could have the SAME cap rate but obviously the 50% unoccupied property is worth more.  So the calculated \"crap\" rate means nothing.  \n\nYes, people talk about a terminal cap rate but all that is is a guesstimate of what you think you can sell for in the future.  It is not based on reality.  \n\nAlso a cap rate measures value and not yield.  That is scammer talk.", "replies": [{"id": "h670a22", "text": "&gt; There is no such thing as \"going in\" cap rate. You are confusing that with going in NOI. If you try to calculate a cap rate on two properties based on actual NOI but one building is 50% unoccupied you could have the SAME cap rate but obviously the 50% unoccupied property is worth more. So the calculated \"crap\" rate means nothing.\n&gt; \nClearly you have your own definition. Let's agree to disagree. Good luck out there", "replies": [{"id": "h670ssb", "text": "NOPE!  There are not multiple definitions.  I just showed you how a 5% cap rate on a stabilized property is not the same as a 50% occupied property where you are using in place NOI to calculate a crap rate.  Geez, I am trying to educate you.  \n\n&amp;#x200B;\n\nPlease show me how you are arriving at a VALUE on a 50% occupied property!  If you can do that surely you can show the math.", "replies": [{"id": "h674eu6", "text": "You\u2019re clearly confused how and when to apply a cap rate. Plenty of resources online out there, check out adventures in cre for some basics up to advanced material.\n\nhttps://www.adventuresincre.com/glossary/cap-rate/", "replies": [{"id": "h6772ub", "text": "NOPE!  I've pointed out their misinformation on this forum before.  Please show what YOU know.  I don't need back up from scammer sites as I know what I am talking about.  Can you step up and show your valuation of a 50% occupied property using direct capitalization or not?", "replies": [], "depth": 14}, {"id": "h677ei0", "text": "Here they were called out by Walina 1001    \n\n[https://www.youtube.com/watch?v=DXzZ8FDLij8&amp;t=27s](https://www.youtube.com/watch?v=DXzZ8FDLij8&amp;t=27s)\n\nTheir response...crickets...how bout you?", "replies": [], "depth": 14}, {"id": "h6790go", "text": "Waitaminnite...Your link is saying exactly what I am trying to teach you,,,\n\n&amp;#x200B;\n\nInvestors often look to cap rates that have been set in the market to begin getting a ball park idea of what they might pay for an asset they are looking to invest in. For example, an investor is looking at a Class A office asset in X market. Class A office buildings in X market have been trading between a 5% \u2013 6% cap rate over the past 6 months, so an investor may look to his or her first year of projected NOI and divide that by a cap rate of somewhere between 5% \u2013 6% to get an idea of the price he or she might need to pay.", "replies": [{"id": "h67kp94", "text": "&gt; his or her first year of projected N\n\n\"his or her first year of NOI\" is what I'm trying to drill into your head! That is the \"going-in cap rate\" You've been focusing on historical noi", "replies": [{"id": "h67lk04", "text": "NOPE!\n\n&amp;#x200B;\n\n**may look to his or her first year of projected NOI and divide that by a cap rate of somewhere between 5% \u2013 6%**\n\n&amp;#x200B;\n\nThey are using a cap rate from a closed analyzed sale with a stabilized NOI.  Geez,  Use your brain.  They are not calculating a cap rate!  the cap rate is already there!  They are calculating VALUE!!\n\n&amp;#x200B;\n\nDo you even know how to calculate NOI?  I'm thinking NO!", "replies": [{"id": "h67ofml", "text": "Look at my excel example from earlier today. I never change the cap rate. The only thing that changes is the noi. NOI is driving the value since cap rate is the same.\n\nhttps://imgur.com/7MurJKy", "replies": [{"id": "h67qayo", "text": "All this model is telling you is that there is a disconnect between the market cap rate and the going in cap rate. That delta between the two cap rates is the \u201cimplied additional risk\u201d of the deal compared to the market \u2014 thats it. Given the lease up assumed here, you would need to do a unleveled discount cash flow analysis to see if that value still holds.", "replies": [{"id": "h68m3mm", "text": "V=i/r  The problem is that there is no such thing as a going in cap rate.  All you have is an in place NOI.  You do not have a Value or rate or really even the i so your going in crap rate is just that.  $300,000 is NOT the value of the property in any situation.  The property \"as is\" is worth $1,012,000 less lost rents, lease up costs and a negotiated risk factor.", "replies": [{"id": "h69lu62", "text": "&gt; ion. The prope\n\nYou're missing the point of the exercise. We're not trying to come up with a value here, we're trying to understand risk. Based on your proforma income and the seller asking price, is this deal more or less risky compared to the market? Nothing more, nothing less. All it does is give you the foundation to base your due diligence on. \n\nAttached are 2 scenarios for the same property, same market cap rate, same proforma NOI. All that is different is the seller asking price. \n\nTo further belabor the point, look at the cap rates based on 2020 Actual / Asking Price. Both are well below the market cap rate. This is because you are looking at the historical value which does not take into consideration cash flows under your ownership. That is your \"crap rate\".\n\nhttps://imgur.com/tme15B3", "replies": [], "depth": 20}, {"id": "h6addb4", "text": "Agreed. We're not talking about value here. We're talking about risk. \n\nhttps://www.ccim.com/cire-magazine/articles/323788/2015/03/cap-rate-variations/ (Certified Commercial Investment Member Group Website)\n\n\"Cap Rate Overview\nA cap rate in its simplest form is a return on an investment based on the principle of anticipation. Value is the present worth of future benefits. A cap rate attempts to quantify the risk profile of the future benefits. It is calculated by using a non-complex formula, R=I/V, where I is the net operating income and V is the value of the property. In more complex terms, a cap rate measures a single-period, unleveraged rate of return on a real estate investment. By converting income into value, a cap rate expresses the relationship of one year's income and value.\"", "replies": [{"id": "h6af6fu", "text": "Cap rates come from an income approach to value called direct capitalization.  They measure VALUE.  They can be indicative of risk but **they do not measure risk.**  \n\nIn Philly CBD Class A office can sell at a 7% cap rate.  In SF the cap rate will probably be 4%.  All that means is investors are buying a dollar of NOI for $25 in SF and $14.29 in Philly. They both probably have the same national tenants.  Can you say Philly is almost TWICE as risky as SF?  NO.\n\n**Cap rates do not measure \"return\".**  In a 10% cap rate market $100,000 NOI sells for $1,000,000 and in a 5% cap rate market it sells for $2,000,000.  Explain why if a cap rate was a return a seller would sell TWICE the return for HALF the price?  You can't.   Also do the math, a cap rate will be exactly the same if I pay all cash or finance 100%!   You are confusing cap rates with cash on cash.", "replies": [{"id": "h6bhe14", "text": "&gt; income approach to value called direct capitalization. They measure VALUE. They can be indicative of risk but they\n\n\nCap rates from a direct capitalization approach actually comes from the pages of bond pricing, specifically annuity bond pricing, where the annual income from the bond is constant and extends into perpetuity. In bonds, the spread between a bond yield and government t-bill  (risk-free) measures additional RISK over the risk free rate. \n\nFor a direct capitalization to work, the property must be assumed to be stabilized AND CAPEX is equal to depreciation. Additionally Cap Rates from a direct capitalization approach do not taking into leverage so its really just one tool in your toolkit for valuation \n\nNot sure where you're getting your cap rates from. Per CBRE's most recent cap rate survey Class A office in Philadelphia was 6.25%-6.75% and Class A office in SF was 4.25%-5.00% -- that's a 35% to 47% difference not 2x. https://www.cbre.us/research-and-reports/US-Office-Cap-Rate-Survey-H2-2019", "replies": [{"id": "h6bjy2x", "text": "1.  Commercial real estate direct capitalization has little if anything to do with bonds.  Those are completely different investment vehicles.  Bonds don't have capex.  They really don't have NOI.\n2. Direct capitalization needs cap rate comps that are based on stabilized NOI.  The property you want to value with those cap rate comps does not need to be stabilized.  In fact you can value a vacant building using direct capitalization.  Why would capex and depreciation have to be equal?  I have never heard that connection before.  Capex is a physical need and depreciation is a tax concoction.  What does leverage have to do with cap rates?  Nothing.  The cap rate is the same leveraged or not.  Finally you agree that cap rates are a tool for valuation.  Correct.  Can you fine tune a valuation with other tools?  Correct.  But a cap rate tells you to the penny what the buyer thought he was paying for a dollar of NOI.  That's pretty damn good! \n3. I do not keep up to the minute on Class A office space.  I'm a retired rich guy.  When I took a cursory look within the last year or so the 4 and 7% were valid.  Your SF low of 4.25% and the Philly high of 6.75% is only a quibble different.  The point was that their risk level was probably about the same even with the difference in the cap rates.", "replies": [{"id": "h6c1i7i", "text": "&gt; te direct capitalization has little if anything to do with bonds. Those are completely different investment vehicles. Bonds don't have ca\n\nThe value of a bond in perpetuity is equal to the payment of a bond (same payment, same period for forever) divided by the yield of a bond.  \n\nWhen comparing it to real estate, the same concept applies for a direct cap approach. The value of the real estate is equal to the stabilized NOI (same noi, same period, forever) by the cap rate. \n\nDepreciation is the amount by which the value of a fixed asset (such as building), is reduced over its entire life span until it reaches zero or its residual or salvage value. In order for the direct cap approach to work, depreciation must equal capex, otherwise your over/underinvesting in the property which impacts NOI. Impacting NOI, impacts value. To your point, bonds do not have  depreciation. In order for direct cap to work, one hypothetically needs to invest an amount of capex equal to depreciation. By investing in capex at the rate of depreciation, it nets out and equals 0. If depreciation is equal to zero annually, the life of the asset is \"hypothetically\" forever. By holding those assumptions true, the yield of a bond in perpetuity is equal to a cap rate. This is why further analysis would be needed to value unstabilized properties since CAPEX/TI/LC is greater than annual depreciation until you \"technically\" get to a stabilized noi.\n\n\"But a cap rate tells you to the penny what the buyer thought he was paying for a dollar of NOI. That's pretty damn good!\" I agree that it tells you what they THINK they are paying for every dollar of NOI. The more compelling question is whether they are over/underpaying based on risk of the deal compared to the market. Even more compelling is using it as a screening tool when looking at deals to see if you're getting compensated for the risk and whether to pursue a deeper dive. See my example from before: https://imgur.com/tme15B3 . \n\nAgreed, leverage has nothing to do with cap rates. It's a back of the envelope approach. Typically a CRE appraiser would do a band of investment test (i.e. weighted average cost of capital) to do a gut check on the cap rate. If there is a large delta between the cap rate and band of investment they may load the cap rate, based on their discretion, to get them more in line. \n\nFinally the SF low should be compared to the Philly low, SF high should be compared the Philly Hight. Class A can range from the newly built sales force tower in SF with 15yrs of lease term to a Class A tower in SF that sold which has a shorter tenant rollover period and/or requires capex.  Assuming this scenario, the 0.75% range in class A office cap rate in SF of 4.25% - 5.00%  (based on actual transactions and most recent noi), tells you that investors are willing to take a less NOI/pay higher value (i.e. lower cap rate) because there is less uncertainty of future cash flows. Less uncertainty means less risk.\n\nSame concept for bonds. Assuming you believe in S&amp;P bond ratings, you would be willing to take pay more for a bond with s&amp;p AAA credit bond than a s&amp;p BB+ bond that has the same payment/terms. Bond payments are more certain with the AAA rated bond. There is less uncertainty in the future bond payments of a AAA credit bond vs a BB+ bond.", "replies": [{"id": "h6e7sva", "text": "&gt;**Agreed, leverage has nothing to do with cap rates. It's a back of the envelope approach. Typically a CRE appraiser would do a band of investment test (i.e. weighted average cost of capital) to do a gut check on the cap rate. If there is a large delta between the cap rate and band of investment they may load the cap rate, based on their discretion, to get them more in line.**\n\nSounds like you took some Guru course.\n\n1. Back of the envelope approach?\n2. Band of investment \"test\"?  If you have cap rate comps you would have no need to derive a cap rate.  \"gut check\"  If the comps are 5% they are 5%!\n3. \"load the cap rate\"  what are you trying to \"get in line\"\n4. This is guru talk used to confuse novices.  Can you explain what you think you are saying without using guru talk?", "replies": [{"id": "h6lwubr", "text": "I've worked on both sides of the table as a lender and as a borrower - no guru classes here. Just lots of deals, working for sophisticated companies, and great mentors in the past 15yrs.\n\nGiven that an appraisal is basically another subjective indication of value, but based on Uniform Standards of Professional Appraisal Practice (USPAP), its important to understand how the appraiser came up with the value given there are a lot of subjective assumptions made. No piece of real estate is the same if you think about it. Even 2 condominium units on the same floor can have different layouts, views, fixtures, etc. When an appraiser does their sales comparison approach they often need to make subjective adjustments to the sales price of the comparable properties based on various shared elements with the subject (location/year/built/condition/occupancy/parking ratio). These adjustments are an attempt to get an \"apples to apples\" comparison between subject property and the sales comps. This will allow the appraiser to compare the property on a price/SF. Note that the sales comparison approach does not come up with a cap rate. \n\nWhen looking at what cap rate to use for the direct cap approach the appraiser will typically look at 3 different types of cap rates to help come up with a conclusion. https://www.appraisers.org/docs/default-source/discipline_rp/dzierbicki-market-abstracted-overall-capitalization-rates.pdf?sfvrsn=2\n\nBand of Investment Test: this looks at the weighted average cost of capital (WACC) for an investor in the market and is calculated as (Interest Rate * % Debt) + (Investor Required Rate of Return * % Equity). This looks at what the required return is for an investor in the market based on 1) how much leverage can get and at what interest rate and 2) how much equity do they need to put in at what is the minimum cash on cash rate for the level of risk they are taking. If an IRR on a potential deal is less than the WACC, that means that your cost of capital is higher than the your underwritten return on the deal.   \n\nSurveys:\nWhat cap rates are institutional investors paying for like-kind real estate. https://www.pwc.com/us/en/industries/asset-wealth-management/real-estate/library/investor-survey.html . This gives the appraiser an indication from more of a macro level what sophisticated institutional investors are paying for a similar property with similar macro characteristics. This data is collected and published by Price Waterhouse Coopers as an annual investor survey. The data is based on actual T-12 NOI at acquisition and the purchase price of real estate bought by institutional players (PE Funds/Pension Funds/ and the like). The data is all anonymized/ then bucketed by market and asset class and is our best indication what sophisticated investors are paying for CRE in the market / asset class.  \n\nLocal Sales Data:\nThe appraiser finally looks at cap rates from recent sales (typically the same properties used for the sales comparison approach) and will use the historical NOI and purchase price (no adjustments are made). The appraiser will either look in market reports or call the broker to find the cap rates for a certain property. These cap rates can be all over the board depending on the number of transactions in the market, number of similar properties, economic changes, etc. In a set of 5 comparable properties, I typically see cap rates range by 2.00%. I have never seen an appraiser point to one property and lean on just one cap rate. That may even make the appraisal not FIREAA compliant, making it invalid for banks to rely on.\n\nThe appraiser then analyzes the ranges and averages of the 3 different methods then SUBJECTIVELY (loads) / comes up with their own cap rate for the subject property. \n\nThis cap rate is then applied to the appraisers STABILIZED proforma of the property assuming the property transfers hands. The indicative value may then be adjusted to take into consideration any cost to stabilize the property to proforma including negative carry, TI/LC, CAPEX. Note that this adjustment is not discounted so it's subject to limitations.\n\nThe direct cap method is then compared to the discounted cash flow method of valuation to figure out the value based on the income capitalization approach. Appraisers typically lean towards discounted cash flow method.\n\nWhat I mean by \"back of the envelope approach\" is that it is a quick and dirty calculation to see if the asking price is makes sense in todays market for the level of risk you are taking - since you're not ready to dive into a full discounted cash flow. The direct cap may only work as an indication of risk if 1) the property is stabilized, 2) the amount of capex needed annually at the time of acquisition is equal to depreciation (i.e. no additional capital needed outside of replacement reserves) and 3) no additional value is created or destroyed. When you start making assumptions outside of this framework the rule no longer holds true - you would need to do a discounted cash flow analysis to layer in stabilization time, debt, and capital cost.\n\nHolding the above true, the yield of a bond in perpetuity is equal to a cap rate. The yield of a bond is made up of two components:  the risk free rate (the theoretical rate of return of an investment with zero risk i.e. govt T bonds) + a risk premium (i.e. the investment return an asset is expected to yield in excess of the risk-free rate of return). For a stabilized property you can assume the difference between the cap rate and the risk free rate is your risk premium.  A risk premium is a measure of excess return that is required to compensate someone for being subjected to an increased level of risk.", "replies": [{"id": "h70hrsz", "text": "Hope that sunk in for you!", "replies": [], "depth": 27}], "depth": 26}, {"id": "h76ac28", "text": "Any thoughts!", "replies": [], "depth": 26}], "depth": 25}], "depth": 24}], "depth": 23}], "depth": 22}], "depth": 21}, {"id": "h6alm2q", "text": "&gt;**R=I/V, where I is the net operating income and V is the value of the property.**\n\nIf an investor has the V what is the point of calculating the R ?  It is a waste of time.  Cap rate calculations are done by third party professional companies on closed sales where they interview the parties to get the details of the transactions so they can calculate in a consistent manner and report  to the market or the people that are paying them.", "replies": [], "depth": 21}], "depth": 20}], "depth": 19}], "depth": 18}], "depth": 17}], "depth": 16}], "depth": 15}], "depth": 14}], "depth": 13}], "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": "gwvc0vl", "text": "One follow up on cap rates.\n\nA cap rate, similar to yield, is the markets signal of implied risk.\n\nExample: Apples S&amp;P credit rating is AA+ and yields a ~2.64% whereas Netflix\u2019s credit rating is B+ \u201cjunk\u201d and yields ~6.4%.\n\nSimilarly Class A infill apartments in the US trade at 4.65% cap rates vs Class C suburban apartments trade at 6.24% cap rates (per CBRE\u2019s 2018 2nd half cap rate survey).\n\nSay that you have 2 apartment buildings that both generate 100,000 in NOI. One is Class A Infill and the other is Class C suburban.\n\nClass A Infill: 100,000/4.65% = $2.15M value\n\nClass C Suburban: 100,000/ 6.24% = $1.60M value\n\nWhile the properties generate the same amount of NOI, investors are willing to take a lower yield because the implied risk is less in a Class A infill location vs a Class C suburban location. In other words, the Class A Infill apartment\u2019s 1.59% lower cap rate creates 550,000 more in value than the Class C suburban apartment \u2014 all because investors feel more confident of future NOI.\n\nThat said, by understanding what cap rates are of comparable properties in the market, you can quickly see if the deal you\u2019re underwriting is generating similar yields to the market. If there is a disconnect, your job is to tease out what is causing the discrepancy (ex below market rents, below market expenses, deferred maintenance, etc) and take that into consideration in your underwriting.\n\nThe next step would be to evaluate whether you feel that cap rate on your investment will move during your hold. To compress cap rates, you can evaluate whether it makes sense to do value add work to convert it to a nicer product and raise rents, assuming there is demand. Additionally cap rates can compress as a neighborhood begins to gentrify as more investment is flowing into the neighborhood and investors are comfortable with a lower yield. The latter is very hard to determine and is never taken into consideration in our terminal cap rate.\n\nTLDR: Cap rate = Implied Risk", "replies": [], "depth": 1}, {"id": "gx8j9jp", "text": "u/Fuck_You_Downvote\n\nu/krussell1205\n\nu/cre-guy\n\nu/HeatFar808\n\nLet me introduce you guys to Irv.   I is for income (NOI) r is for cap rate and V is for value.  You need 2 of the 3 components to make any meaningful calculation.  At best a cap rate can approach 0 but never hit it.  A  .000,000,000,1% cap rate means that $1 of NOI sold for $10,000,000,000!  See, it is a value metric that you should learn if you are going to be in commercial real estate or post on a commercial real estate forum.  Any questions?", "replies": [], "depth": 1}, {"id": "gxw0gav", "text": "This depends on who is evaluating the property. Buyers will want to have\u00a0a high cap rate, meaning the purchase price of the property is low. On the other hand, the Sellers want to see a low\u00a0cap rate\u00a0because the selling price is much higher.  \nThe capitalization rate or CAP is used to determine the return on an asset. The rate is expressed as a percentage and calculated by dividing a property's net operating income by the property value. Cap rates have an inverse relationship to the property value. The lower the cap rate, the higher the purchase price and vice versa.   \nExample: If the net income of an investment property was $50,000 per year after all expenses.   \nBuyer A would end paying $1 million for this property based on a 5% cap rate.  \nBuyer B would end paying $714,286 for the same property if they can negotiate a sale based on a 7% capitalization rate. Thus, the higher the cap rate the better the investment return!", "replies": [{"id": "gxxxvis", "text": "&gt;The capitalization rate or CAP is used to determine the return on an asset.\n\n**CAP RATES ARE NOT A \"RETURN\" METRIC**. Scammers want novices to believe a cap rate is a \"return\". They buy at 14% cap rate (V=i/r $7.14=$1/14%) and sell to you at a 10% cap rate ($10=$1/10%) They are making $2.86 off every dollar of NOI they sell you. Hmmm\n\nYou will see most of the **Youtube scammers** claim that a cap rate is the unleveraged \"return\"!!! Total scammer talk. If a cap rate was a return then explain why the seller of $100,000 NOI in Podunk can only get $1,000,000 in a 10% cap rate market but the CA seller can get $2,000,000 (5% cap rate) for the same $100,000 NOI. Why sell TWICE the \"return\" at half the price. LOL", "replies": [], "depth": 2}], "depth": 1}, {"id": "gyhuflv", "text": "In not sure if In just starting to notice this , or if its a new phenomenon. I see a lot of brokers headlining the exit cap rate.", "replies": [{"id": "gyi06r3", "text": "As more unsophisticated buyers enter this space there will be attempts to razzle dazzle them with fake numbers.  It is hard enough to analyze and calculate a cap rate on a recent sale.  For a broker to think they can accurately predict rents/expenses/cap rates years ahead is just puffery.", "replies": [], "depth": 2}], "depth": 1}]