Welcome back! For today, we are continuing with another addition to our real estate fundamentals library and we are going into depth on one of the most important real estate calculations to understand and be able to calculate quickly for your entire real estate career.
That’s right! I am talking about capitalization rates, AKA cap rates, as it relates to real estate properties, assets, and real estate lingo cap rates are one of the foundational and most widely used in the entire investment real estate industry. Why? Because it’s easy to calculate. It’s all about speed with this calculation. The cap rate equation has many applications in investment real estate and allows investors to analyze a ton of information extremely quickly.
Making cap rates a must-know for investors, whether you’re a seasoned veteran or you’re brand new, I would say that you can’t even get through the beginning stages of a real estate career without knowing cap rates and their impacts in depth because this calculation is that widespread and it’s that important. Knowing this calculation will arm you with the ability to quickly analyze everything from returns, comparable properties, and many more, and even give you the ability to estimate the value of buildings that you see while driving down the street in your everyday life. Can you imagine just driving down the street and being like 15 million, 5 million, 50 million, 80 million? You can do this if you understand the fundamentals of cap rates and you understand just a couple basics in the market that you’re driving around in, there is so much value in this one quick equation that I can’t wait to share it with you.
So let’s jump into everything that you need to know about real estate capitalization rates, AKA cap rates.
For those that don’t know me, my name is Nick DeAngelo with Saint investment group, we currently have over 150 million in real estate assets under management today, and we are also raising an additional 100 million to buy more real estate assets and grow the portfolio for our investors. If you wanna learn more about investing with us, go to saintinvestment.com, where you have all the information you need for all the funds that we have available.
Now, the reason that I make these videos is because I believe that real estate is the number one way to financial freedom and I want to arm you with the tools to go out and invest yourselves or find somebody good and professional that you want to invest with. Also, as a reminder that I am not your attorney, not your accountant, and a financial planner. So check with your professionals before making any financial decisions, because every investment has the risk of loss and your specific situation is different than everybody else’s. It’s better to talk to your people before doing anything.
So for today, here’s the outline of how we’re gonna learn about cap rates. First, we’re gonna jump directly into the calculations and the definitions and if you just need a quick answer, you’re gonna get what you need in a second. Next, we’ll discuss and show some examples of other ways that a cap rate equation can add major value and provide a quick understanding of an asset in very big and important ways. Next, we’ll go over some market fundamentals that can impact cap rates higher or lower so you can understand the market dynamics behind a rise or fallen cap rate in any given market. Then as a bonus, I’m gonna show you how to use the concept of cap rates to add potentially millions to the sales of your properties, by just understanding simple math and how to apply it to your property’s financials. when it comes time to sell.
All in all, we’re gonna learn a lot of fundamentals, a lot of theory, and ways to make a lot of money.
So let’s jump in.
A capitalization rate, AKA a cap rate is a real estate term used to indicate the rate of return that is expected to be generated by a real estate investment property. The keyword there is the rate of return. Simply put this is calculated by dividing the property’s NOI on the top by the current market value or sales price on the bottom. So it’s NOI over value. That’s it, as far as the equation goes. The results of that ratio are expressed as a percentage and that percentage is an estimation of the investor’s expected return on that real estate investment. Most importantly, what the cap rate does is it allows you to compare the relative value of one property versus the relative value of another.
If you’ve been listening to me for a while, you know that first and foremost, that II recommend an income approach when it comes to analyzing investments, using cap rate, you can get the relative value of one asset to another using that approach. Also worth mentioning is that cap rate is the single most popular metric to evaluate this and it’s also one of the simplest and because it’s so widespread, it’s something that can be used very effectively when dealing with other investors when dealing with brokers or agents or anyone involved in the investment real estate space, because they all understand it. So you need to as well. So let’s dive into a couple of the details here, because this is a very simple equation, so it can’t cover everything. So what does it not cover? So first off cap rates cover essentially a one-year time period.
It’s a snapshot of what happens at the time of purchase. Also in this simple cap rate equation, it’s assumed that you’re purchasing the property for all cash and not with a loan. So simply put the capitalization rate indicates the properties, intrinsic, natural, and levered rate of return. Also, cap rate does not cover future considerations like rent increases, property appreciation, any future market changes that are massive or drastic, or any loans that will be placed on the property now or in the future. Essentially cap rate is a quick snapshot of immediate return if you bought the asset for cash today.
All right, so let’s jump into the equation. What exactly does it look like when you dive in here? Here we have it, cap equals NOI over value. So looking at that equation, you can see it’s relatively simple. It’s a great snapshot of that exact moment and there are two ways to input the denominator, meaning the lower number. The first can be the current market value. Although that can be a little ambiguous. If you ask the seller, they might think it’s much higher. If you ask a buyer that might be much lower, so the value can change and fluctuate, but it is very helpful so that, you know, at any given moment with looking at a property for you to purchase, but if you take the NOI versus the sales price that they’re offering, that’s the cap that you’re looking at. If you’ve already purchased the property, came to an agreement in escrow, for instance, you have a set price there. So it’s NOI over that price over time as the the property would likely appreciate this quick map will give you a good idea of how your income will continue to increase in relation to the initial purchase price.
So, one question that’s asked very often is what is a good cap rate and what is a bad cap rate? What’s the range of good versus bad cap rates? The answer is there’s not an exact science to this number’s good, and this number’s bad. It depends on every single market. And while there are no clear and distinct guidelines of exactly, what’s a good, or what’s a bad cap rate. We do know something very important about cap rates and it’s that cap rates typically give us a good idea of the measure of risk in an asset as well. Cap rates give us an idea of risk in two ways. The first is if you take certain markets and you just take cap rates in different areas within those markets, oftentimes not a hundred percent of the time, but the higher cap rate areas are gonna be areas with maybe older properties or more crime or other balancing factors that drive down the cost and the sales price of that property in relation to its NOI, AKA raising the cap rate at the end of the day.
On the other end of the spectrum, you might find pristine class A, properties that are brand new construction with excellent locations, and these might command much higher purchase prices, AKA lower cap rates in relation to their net operating income, and that right there within one market will give you a good indication of some risk of one side of the market versus the other. It’s just like any risk versus reward scenario in investing. Typically you’re gonna get higher returns for taking on more risk and more headaches.
The second-way cap rates can tell you a measure of risk and an investment is when, you know, on the other hand, what loan rates are doing. If you’re in a position where you’re purchasing a property and you know that you need a loan to complete the transaction, then the cap rate is a quick gauge that you can compare to your loan rate to make sure that you are not underwater. One of the worst things that you can do is become underwater because your cost of capital is too high. I’ve seen this many times. Banks are much tighter on this and they won’t even lend to you often if you’re cutting it too close, but never get yourself in a position where you look like you’re gonna be underwater.
For instance, let’s say you’re purchasing a class B property in a major Metro. Let’s peg that around a five cap in current market conditions throughout the US and for a nice, clean, easy number. Now, if you’re getting a five cap, AKA, a 5% capitalization rate with the NOI versus the purchase price. So 5% you’re getting versus let’s say for this example, a 4% loan rate, that means your returns five and your cost of capital alone is four. That’s cutting it really close to one small bump in the road, or one thing you didn’t consider, that can wipe out any and all profits and you are working for free or at a loss and you may lose that property. That’s scary. Don’t make that mistake. But what cap rates can give you is that very quick and dirty five cap versus 4% cost of capital on your loan. You know, you’re cutting it too close in that scenario.
Another incredible time-saving tool that cap rates can be used is for property comparables in a given market. For instance, if you’re looking to potentially sell your property and someone is offering you a seven cap, but you know, the market rates for cap rates are 3.5%. Then that person is essentially offering you 50% less than the market 3.5% to seven doesn’t sound that massive, but that’s a 50% difference in the sales price of your property. They’re trying to take you to the cleaners on that sale. Now, this gets even more important when you’re looking at multiple comparables in one market. If you have 10 properties that you’re lining up and each one has slightly different characteristics, size is slightly bigger or smaller. The yard space is a little different, parking’s different, etc.
Having those cap rates and seeing all the different cap rates under different conditions allows you to have a much better understanding of the market. It’s very powerful and cap rates are extremely important when you’re looking at comparables.
Now let’s say you’re looking at all these comparable properties and all these comparable numbers. What exactly does cap rate mean in relation to returns? I’m gonna give you one example, so you can use cap rate, to visualize your returns in a different way. One way to look at the equation is how long it would take you to make 100% on the investment of your purchase price funds, AKA, how long would it take to get your money back? Well, I’ll tell you at a 10 cap, it would take 10 years to get your money back on your purchase price. We’ll start with an example of a 10 cap, AKA, a 10% capitalization rate in a 10 cap scenario, you would take 100, which is 100% of your purchase price and you would divide that by 10, which equals 10 years to get your initial purchase price back AKA a 100% return.
Now let’s change it up. Let’s use a five cap as the number. How long would it take you to get a hundred percent return on investment with a five-cap purchase price? Let’s do the math 100 divided by five equals 20 years.
So another way to think of a five cap is it would take 20 years to get a hundred percent ROI from your net operating income alone. This is a big concept that it’s really important for you to understand. There are many ways to boost return significantly, but this just gives you a time horizon on your net operating income. This is important. Now, as I mentioned earlier, cap rates are all about speed. Most of the value that cap rates offer is the ability to analyze a property very quickly in different ways. One of the best ways to apply cap rates is to work actually backward with the end goal of finding the estimated value of a property.
When I talked in the intro about the ability to look at a property and estimate its value just on the fly like that, this is what I’m talking about. In real estate, we call these drive-by numbers. It’s the skillset of mental math combined with basic market knowledge, of the market that you’re driving in to compare those to come up with quick estimates on what you’re working on, what you’re driving through to understand your market a little bit better. I can’t tell you how many times I’ve been sitting in the car with a JV partner, a client an investor and we have just been driving by analyzing real estate, just with mental math. This is absolutely critical to your real estate success as being able to do things on the fly. Let’s jump into an example and I’ll draw it out for you so that you can see firsthand what this looks like.
Let’s say you and I are going for a site drive in my local market in Southern California and we pass a class A beautiful brand new construction, concrete tilt-up, giant stunning industrial building. Now I know from experience the market that caps for this type of product is right around the 4% range. So if you, and I see A class, an industrial building, and we know those typically go for our forecast, then the next thing we need to do is find the square footage of the building. Now because you and I are really good at real estate. And we have a ton of experience. We estimate the size of the buildings, let’s say about 30,000 square feet also because you and I are really good at real estate in our local market.
We know that average leasing rates for this type of product go for about a dollar 50 per foot and with a little quick math, we know that it equals $45,000 per month or $540,000 per year in net operating income because this is a triple net property and in triple net properties, we know that tenants pay for all expenses. So the income number becomes net for the most part to the landlord. So we have a $540,000 NOI and we have a four cap. So how do we find what we believe to be the market value of the building? Let’s check out the math. All right. So for here, you see, we have a four cap. We have the NOI of 540k cap rates are expressed as percentages. So we have the four over the 100 meaning 4% meaning a four cap. So we have four over 100 on one side, we have the NOI on the other, the 540,000 above the value, right?
For this, we’ll say market value and we’re looking for market value. As the equation to do the full math, we would take to do the full math. We would take 540,000 times 100 divided by four. And that equals, 13.5 million for that deal? So just having the NOI and the capric, you can solve backward and you can find what the market value of a property is. Do you see how powerful this is? That means you can drive by properties and know in a couple of real quick, simple estimations. You can pull out the value of any property or drive by. Also, if you’re a smart tech savvy person, you don’t even need to know your market. You can pull it up on your phone, right there, and pull a bloop net or co-star or any of the listing services and see what comparable properties are doing.
That means you can do that on the fly in the car and find actual values for things around you, including the exact square footage of properties. You’re looking at and it’s all there at your fingertips. You have it.
Now, this wouldn’t be content of mine. If I didn’t show you a couple of shortcuts on how to calculate this even more quickly. So you see in this math here, we did five 40K. We found it is times 100, which we pulled from there divided by four, which we pulled from there, right? And that gave us the answer of 13.5 million. Here’s a faster way to calculate all of it. Instead of going through the full process. You take the 540,000 and you just divide it by 0.04, AKA 4%. And that equals $13.5 million Just like that, you did it in two steps instead of three.
So you take the NOI, divide it by the cap rate in a decimal format, and that will pump out the market value of the property. You’re looking at it just like that. This is killer and it’s very helpful.
Look at that. You’re a freaking pro at cap rates now, you know how to calculate them in front words, you know how to calculate in backward and find the value of a property and you know, all the basics and fundamentals for why cap rates are important. Let’s jump into some market dynamics of how you can see cap rates rise or fall in a market and why that’s the case. And then we’re gonna end with a real-life example of something that we did to generate nearly an extra million dollars of sales price just by making one tweak, using cap rate as an analysis tool.
So typically in the market, you’ll see that cap rates and mortgage rates are deeply related as mortgage rates go up very often. You’ll also see cap rates go up. So that means when the cost of your money, AKA, your loan gets more expensive and the interest on your loan is more expensive. Every single month, landlords need to lower the sales price of their property. And as we know, the cap rate is a measure of return, which means cap rates go up as sales price goes down. As you see loan rates go up, you’re gonna see property values go down and you’re gonna see cap rates go up. Meaning the returns go back up. The reason for that is as loan rates go up, properties are harder to afford. The cost of those dollars is more expensive. So what ends up happening is less people can compete. So demand drives down. Additionally, the investors that can compete and do want to buy need higher returns to offset all these extra expenses that they’re incurring on the lending side, when this does occur and you see cap rates rise, we call that cap rate expansion, meaning cap rates are getting bigger.
Meaning returns are getting bigger on properties. Well, the opposite of this is when cap rates go down or they get smaller AKA cap rates compress, they call that cap rate compression. And that’s very common when loan rates also go down. So what you should do is anytime you’re seeing loan rates increase, you want to think about the impact on cap rates in different markets and keep an eye out for opportunities that may have been caused by those higher interest rates. If you’re a cash buyer, this is an amazing opportunity for you as well.
Now that we know all this about cap rates, how do we use all this information to arm ourselves in a way where we can squeeze out and maximize returns to ourselves and our investors? Now, when you’re selling a property, the goal is always to sell the property for as much as possible. Doesn’t take a rocket scientist to know that. But the interesting thing to consider is that when someone’s buying a property, typically they’re buying it based on the financials that you’re providing to them. So you want to scrub your financials and make sure you’re, property’s operating very tight, but, it gets difficult in a lot of those moments because there are these huge financials with many line items. So how do you make different decisions and how do you determine what’s valuable for a sale? And what’s not in your decision-making to tighten up your financials? You use cap rate as a lever and you keep it in mind at all times when you’re evaluating. For instance, if you have all of your costs and expenses already sunk into the building and you’re below market on your lease rates and you raise lease rates that essentially go directly to your bottom line, your NOI, right?
So look at these numbers because we use this as a real-life example, we found a way for a property to increase the NOI by a mix of raising rates and lowering expenses. We raised the NOI by $3,000 a month. That’s great. That’s a big boost in income, three grand a month. This is a pretty big property. So three grand a month. Really wasn’t all that big for the size of this property, but the impact was bigger than $3,000 a month because if you take $3000 and you multiply by 12 to get it an annualized number that’s $36,000.
That’s a boost to the NOI. But wait, because we’re talking about a sale of this property, and this property sold around a five cap rate. So if you take that same $36,000 that was added to the net operating income and you compute that with a 5% cap rate, what you end up with is $720,000 added to the sales price by that one $3,000 increase in monthly NOI.
Do you see how massive that is for a $3,000 increase? We made an extra $720,000. That is the power of cap rate because when we went through the expenses and we went through the income, we knew that if we tightened it up in a couple of areas and ran a little more efficiently and boosted rents just a little bit, the impact was massive. We made almost a million dollars with a couple of slight changes. And in addition, we got to recoup that money today. We didn’t have to wait 20 years to get that money. The buyer paid us for that today because that money was based on a cap rate basis. It’s extremely powerful stuff to think about it in those terms. It’s how highly strategic and intelligent investors look at every dollar on their property’s financials, because they know the impact that it has on end sales, price and value.
All right. I hope that deep dive into capitalization rates, AKA cap rates was extremely helpful for you and you know, the ins and outs, how to calculate cap rates and how to use them to boost return and get quick answers on different metrics. As it relates to an income property.
As a reminder, we have a ton more great information on our real estate fundamentals playlist. So check them out and keep building your education and your investor’s skillset.
President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.