ELI5: Cap Rates
Preface: I'm a young broker in WI with 1 year of experience, mostly in leasing, but no formal education in commercial real estate (I was Pre-Law in undergrad, aiming for RE Law in the next 5 years). I am trying to bridge the gap into some of our sales. I think I need to demonstrate a better knowledge for the industry (and market, but that's on me) before I ask my boss to bring me in on some of these deals or present him a proposal. Cap rates, for whatever reason, I just can't get it.


I searched through a few pages of results from this sub but couldn't really find what I'm looking for. I am having a bitch of a time understanding Cap Rates. So please, could someone Explain Like I'm 5, What do they indicate? How do they work? Why do buyers like high cap rates and sellers like low cap rates? Can your quality of tenant affect it? Other major factors that affect it? Anything you guys can share is great.
[{"id": "czxgsiy", "text": "ELI5 Version: Let's say you have $1,000.  You want to invest that money.  You have many different things that you can invest it in (stocks, bonds, real estate, a savings account etc...).  You want to choose which type of investment you make by how much money you get back.\n\nIf your bank account gives back 0.1% interest you would make $1 per year.  A bond maybe pays you back at 2%, so then you earn $20 per year.  The real estate has a 6% return (this is the CAP RATE) so you earn back $60 per year.", "replies": [{"id": "czxha0q", "text": "Non ELI5 notes: The above illustrates what a Cap rate is (a measurement of your rate of return), so whey do buyers \"like\" high cap rates and sellers low cap rates?  \n\nBuyers \"like\" high cap rates because they are getting a higher return... would you want to buy a property that is going to return 5% per year or 10% per year?\n\nSellers \"like\" lower cap rates because that means the sale price is higher.\n\nThe magic formula for Cap rates is V=I/C, the variables in this are V=value (think sale price), I=Income (how much does the property bring in each year after paying all of the bills (but not counting any mortgage), and C=Cap rate (or the rate of return on your investment... see ELI5 above and when you plug this number in remember that it is a percentage).\n\nAll you need to know are two of the variables and you can figure out the third.\n\nTo understand it better here are a few examples that you can try, What is the value of a property that makes $10,000 per year at a 10% cap rate?  What is the value of a property that makes $10,000 per year at a 5% cap rate?  What is the cap rate for a property that is selling for $1,000,000 and pulls in $60,000 per year net income?\n\nGood luck!", "replies": [], "depth": 2}], "depth": 1}, {"id": "czxj64w", "text": "In simple terms, a cap rate is the unleveraged rate of return at a given purchase price or value. \n\nYou can also turn it around to use different ways. The three pieces are Price (or value), NOI, and cap rate.  \nNOI/price = cap rate  \nNOI/cap rate = price  \nprice*cap rate = NOI\n\nedit:\nBuyers like high cap rates simply because they want a higher return. A higher cap rate on a given NOI will result in a lower price. Buyers want to pay less for their income. When they buy income property, what they're really buying is a series of cash flows. If NOI is projected to be $100k, wouldn't you rather pay $1 million than $1.2 million for that income?\n\nSellers prefer low cap rates for the exact same (opposite) reason. They want the NOI that they're selling to be worth more. If they can sell the $100k NOI at an 8% cap rate, they'll receive a higher price than if they sell at a 10% cap rate. \n\nQuality of the tenant(s) absolutely affects cap rates. It's a much more secure investment to buy a property with a lease guaranteed by Wal-Mart than by Joe's Fly-by-night startup. A tenant with better credit justifies a lower cap rate. \n\nother notes: don't just accept some broker's estimate of NOI for a property. Question his assumptions. Is he pricing the property as if it has 100% occupancy when in reality the place is 30% vacant? Are the expenses realistic? Is the property needing major capital improvements that aren't priced in? Agents always want to present the best possible picture and often fluff the price. \n", "replies": [{"id": "czxzwe7", "text": "Another perspective is risk... high cap implies higher risk and low cap implies lower risk... if 2 shopping centers are generating exactly the same income,... one is filled with local businesses with less than a year left on their leases and the other one is long term Starbucks and Panera on 10 year leases, which would you pay the most for? You'd pay the most money for the SBUX/Panera (less risk, lower cap, higher price)", "replies": [], "depth": 2}], "depth": 1}, {"id": "czxj6ov", "text": "It is the ratio of net income to the value of the asset.  Say that 5 times.  It is not a return.  It is a pricing metric to scale similar assets valuations.\n\nLets say I own a business where I sell ice.  I am interested in investing in some new ice machines, and want to know how much is a reasonable amount to pay for a variety of ice makers.  I could look at how many ice cubes each machine makes a day then divide that by the price of the machine to figure out what my return is.  This is similar to a cap rate, but the problem (as with cap rate) is it is a particularly poor way to actually judge return.  A much better way to judge how many ice cubes you will get from each dollar you invest is to look at every machine available, judge how long they will last, what they cost to maintain, how much energy they use, how reliable they are, what the resale value is, what warranties are available, what the manufacturer or sales people may lend you on them so you can buy more machines with your money etc.  The problem is a lot of that information is really hard to actually get.  My personal situation is probably different from others too, so maybe even if a very efficient market I'd pay way more for a machine I know won't break, ever, because if it does I have my last dollar in this and I'm screwed.  Or maybe the opposite is true, I have unlimited funds, I'm going to buy 1000 ice machines and have a team of mechanics there 24/7.  I want as many ice cubes as possible for as cheap as possible, I could care less if they are reliable or not.  \n\nThis is the problem cap rates solve.  They lend us a really good metric to utilize to figure out what a normal market seller and buyer will transact at, in a way that the actual value of the property doesn't matter.  It is all about measuring risk and observing similar transactions.  \n\nSo say there are 3 ice machines I am thinking about.  \n\nIce machine 1 makes 10 cubes an hr and costs $10.  \nIce machine 2 makes 25 cubes an hr and costs $50.  \nIce machine 3 makes 100 cubes an hr and costs $25.\n\nSo I have ice caps of 1, .5, and  4.  Higher is better right?  buy 3 and call it a day?  Well no, this isn't what we use cap rates for.  \n\nWe use cap rates to look at machines similar to 1/2/3 to figure out what 1/2/3 are worth (with limited regard to how often they actually make cubes).  \n\nYou see maybe 1 is your pretty standard ice cube maker.  Lets say 2 year warranty, kinda expected construction and parts etc .  If I had to I can probably go to my bank and get an equipment loan on it.\n\nNow 2, 2 is a beast.  2 is all stainless steal, 10 year warranty, very reliable.   Anyone will loan me money to buy them, as they are easy to resell and in demand.  \n\n3, holy hell it sounds great, but its from the back of some guys trucks and every 10 minutes he has to kick it to keep it going.  It is loud as fuck, comes with no warranty, and I think it is going to need some serious attention.  Absolutely no one is going to loan me money to buy that because they don't want to have to figure out what the hell is wrong with it if they get it back.  \n\nNow these all have values, but pricing them off each other is pretty hard to do.  They don't have a lot in common.  I can clearly see differences, but putting an actual dollar amount on them is rough.  \n\nSo lets take a closer look.  I talk to my ice making friends and family and they tell me about their ice makers.  Everyone starts yelling they bought this for that and that for this and I say hold on, everyone shut the fuck up.  \n\nI am looking at a machine that is pretty standard, like you'd see in a normal fridge.  It has a 2 year warranty.  Combination plastic, metal etc.  Anyone buy anything like that recently?  I might have to ask my bank for some cash for this, so I'm expecting it is a model they won't have a problem with.\n\nA few people say, yeah sure man, we just bought units like that.  They were:  \n\n100 cubes for $90, 5 cubes for 4, 35 cubes for 30.\n\nWell shit none of those are worth anywhere around $10.  So I figure out what the ratio is between the production and the cost.  I wind up with 1.11, 1.25, 1.16.  That is slightly helpful.  So  options one appears slightly more expensive than what I see other ice makers selling at.  \n\nI thank these folks and say, ok next up I got an option to buy a beast.  I drive a tank over this fucker, its impossible to damage.  Anyone have anything like that?  \n\nThey say sure man we got 50 cubes we paid 100 on, 10 cubes we paid 19 on, 35 cubes we paid 70 on.  I do some math and get .5, .52, and .5.  Ok that seems priced about where I'd expect.  \n\nOk next up, anyone buy any thing very questionable and shitty lately?  I'm talking the kind of stuff if you lean on it, it might break in half?  \n\nThey say sure man some dude has been selling those out of the back of a truck.  If it break good luck finding him lol.  Crazy good deals though.  We got a 100 cube one for 30, a 500 cube one for 200, and a 50 cube on for 15.  I do some math and get 3.33, 2.5, and 3.33.  That is probably a pretty good buy at 4.  \n\nSo which one do I buy?  No clue, my tolerance for risk and the actual costs and returns for running these over a longer period of time determines that.  What I did figure out is 1 they are asking too much money for, 2 they are asking about the right amount, and 3 they are willing to sell for less than it is worth.  \n\nThat is what cap rates tell you      \n", "replies": [{"id": "czxkrzj", "text": "The correct answer is, you buy a frozen Margarita machine instead. ", "replies": [{"id": "czxkzgl", "text": "http://40.media.tumblr.com/12ad8d00f31807ab38af5148b8c54eac/tumblr_mzx2xyopIa1t6cr7go1_1280.jpg\n\nthats how we got the last crash ;)  \n\n", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "czxkj7g", "text": "Higher Cap Rates = Less expensive/valuable property ($900,000 instead of $1,000,000)\n\nLower Cap Rates = More Expensive/Valuable property ($1,100,000 instead of $1,000,000)\n\nIncome/NOI can also affect the cap rate...$125,000 vs $100,000\n\n**Example:**\n\n$125,000/$1,000,000= 12.5% Cap rate\n\n$125,000/$900,000= 13.8% Cap Rate\n\n$100,000/$1,000,000= 10% Cap Rate\n\n$100,000/$900,000= 11% Cap Rate.\n\n\nGenerally, in today's markets Cap rates range from 3-7%, depending on market. As prices go up, cap rates go down and companies/investors are having to put in more money to make the same cash flow returns.\n\n\n", "replies": [], "depth": 1}, {"id": "czxkx8o", "text": "Here you go mate.. These helped me:\n\nhttps://www.getrefm.com/model-for-success/truly-understanding-commercial-real-estate-cap-rates-capitalization-rates/\n\nhttps://www.biggerpockets.com/renewsblog/2014/05/10/cap-rates-cash-cash-returns-explained/\n\nhttp://www.realdata.com/blog/how-to-estimate-resale-value-using-cap-rates/", "replies": [], "depth": 1}, {"id": "czxmh03", "text": "Cap Rate is one of the simplest ways to discuss the price of an investment property compared to the income it generates. \n\nIt's calculated as income / price: If a property generates 8,000 and you pay 80,000 then it's an 10% CAP(8/80). If you pay 100,000 instead it'a an 8% CAP (8/100).\n\nYou can think of it as a simple return. If it offers a higher return that's better for the buyer because they're getting more for their money. Note that it's the inverse of the price, which may be what you're negotiating, so the higher the price, the lower the CAP.\n\nThe quality of tenant does not impact the income but it may impact the price you're willing to pay. Maybe you need a 12% on that crummy tenant but for well-rated national firm you'd do it at a 7.", "replies": [], "depth": 1}, {"id": "czxrfns", "text": "The cap rate is the NOI divided by the Value. This seems like a random equation, so why is this important?\n\nThe best way to understand cap rates is to understand what they are used for. They are mostly used to determine the value of a building. If I am looking to buy an office building, how do I know how much to pay? Every office building is different, in terms of size, income, age, etc, so I cant just say I'm going to pay $30M because the last office building went for $30M. You need to compare apples to apples, and the cap rate helps you do this.\n\nLet's say I'm looking to buy the \"Shank6510 Office Building\", which has an NOI of $1,000,000 per year. How do I know how much this is worth in the current market?\n\nI find 10 recently transacted office buildings that are roughly similar in size and age to the Shank building. This is easy to do using Costar, REIS, etc. These services will usually show you what the cap rate is for each building (which is just telling you what the NOI is for each building, right?). Take the average of those 10 cap rates. Let's say the average is 5%.\n\nTherefore, in the current market environment, the Shank Building is worth ($1,000,000 / 5%) = $20,000,000\n\n", "replies": [], "depth": 1}, {"id": "czxvfjn", "text": "Everyone here is right, but I feel that they are missing a point: How do you determine the appropriate cap rate to apply to a property's NOI. \n\n\nThere are two main methods: market extraction and band of investment.\n\n\nMarket extraction is the process of finding the cap rates for recently sold properties, comparing those properties and the risk involved in the investment to your property and determining whether a higher or lower cap rate is appropriate. \n\n\nBand of Investment used two factors, the mortgage component and the equity return (equity dividend rate). Briefly stated, how much will you have pay for your mortgage each year, and what return do you want to make on your down payment (equity). ", "replies": [], "depth": 1}]