Cap Rates 101

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Next week’s show is going to be another technical show about rent increases, both from the standpoint of how to calculate maximum allowable rent in Rent Controlled jurisdictions and determining market value and long-term success in non-Rent Controlled areas. Check it out!

The following week, June 15 I’m going to be back on the radio with Brian Copeland for the Brian Copeland Show on KGO 810AM at 3PM. Join me on the air, I won’t be doing an online show that week. I’ll be a the Giants game on Wednesday anyway!

Trivia question: When you get a loan for your apartment building your lender may ask for “points” which are an up-front fee on the loan. How much is one “point” worth?

When you’re thinking about buying and investing in apartment buildings the most important measure of value is the capitalization rate or “cap rate.” This is a way to express the net operating income in relation to the purchase price to show how much of a return you get on your investment in the building. Essentially, it’s the amount of money you’d make after paying all expenses if you paid all cash to acquire the building. 

The equation for cap rate is net operating income divided by purchase price. 

Net operating income is calculated by figuring the gross income less vacancy loss (typically around 3% of gross income) to calculate effective gross income. Leasing fees are included as part of the “vacancy cost” and are not considered the same as property management fees. Then you subtract all operating expenses to find the NOI. Operating expenses are all expenses necessary to operate the building including items such as:

  • Utilities
  • Property taxes
  • Insurance
  • Repairs and maintenance
  • Pest Control
  • Professional services (including property management, accounting, legal services)

Notice that the cost to pay the mortgage is not included in this list. Debt service costs are not part of this calculation because they can vary dramatically and they don’t directly relate to the ongoing operation of the property. 

Doesn’t include the costs of capital projects. When you buy a building that needs work you need to be able to pay for that work without necessarily relying on the rents to pay for it. You don’t get to write off the cost of large capital projects (roof repairs, seismic retrofits, etc.) entirely in the year the work is done and the bills are paid. You have to pay for them all at once, though, so even if you don’t have many expenses in a single year, you’ll have to pay the piper in the future when the work needs to be done.

Pitfalls of looking at cap rates

  • Overstated rents (bad for buyers)
    • Overrepresentation of fair market value for currently vacant units - you buy it expecting to get those rents and you find you can’t get close.
    • Actual rents at above-market rates that are not sustainable for buyers
  • Underserved expenses (bad for buyers)
  • Oversubscription to services (good for buyers) - too much trash service, possible to reduce and still comply with required service levels.
  • Falling in love with “potential” - sellers’ agents like to show potential rent as a part of their presentation of a building and then ask for a higher price based on this “potential.” You should definitely verify what you think the units are worth at fair market but you shouldn’t pay more to acquire a building that has a higher potential rent. You have to do a lot of work to achieve that higher potential rent so you should get paid to do that work, not pay the seller more to buy the opportunity.

When should you expect to get a higher cap rate? Buildings that experience more or longer vacancies or are in more challenging neighborhoods typically sell for lower overall prices so they have higher cap rates. This helps the owner to compensate for these lost revenues or for the costs of operating more difficult buildings. For example, if you’re operating a building where tenants have a harder time paying rent and you have a higher risk of eviction costs or other related costs like vandalism etc. you’ll want a higher cap rate to help give you that cushion to make those payments. Typically buildings in difficult neighborhoods get a higher cap rate (lower prices for the same NOI as comparable buildings) because it’s necessary to attract buyers. 

You typically compare cap rates to mortgage rates to determine whether buildings are selling for a reasonable price. If your cap rate is higher than the interest rate on your mortgage, you’re making money. If it’s less than your mortgage rate you have to put more cash down to buy the building and have any chance of making a profit. In SF cap rates have dipped as low as 2% in the past few years. I’ve noticed them inching up lately into the fours but it’s still not really an attractive rate. Interest rates are going up so cap rates should rise as well because money is going to be more expensive. 

If I could only use one calculation to determine the value of a rental property investment it would be the Cap Rate

  • Cap Rate is the single most important calculation because:
  • How to Calculate Cap Rate:
  • The Cap Rate calculation is calculated by: 
  • How to apply Cap Rate to your property search
  • Comparing Cap Rates between properties
  • Cap Rate History in SF
  • What’s the average Cap Rate in SF, OAK
  • Be careful, Cap Rates can be skewed, here’s how to find out if its legit
  • What can Cap Rates tell you about a property?
  • Are there Cap Rates that are too good to be true?
  • What makes for a good Cap Rate?
  • Don’t get sold on rosy potential, pay for today’s income
  • Live Cap Rate Demo

Trivia question: When you get a loan for your apartment building your lender may ask for “points” which are an up-front fee on the loan. How much is one “point” worth? 

Answer: One percent of the value of the loan. If you borrow $1M you pay $10,000. 

Are You Kidding Me?! Kitchen smells as a “right to quiet enjoyment” issue.

J.J. Panzer