Week 11: Debunking Cap Rate

This had me confused for a while

Condensed section on a topic that confused me for a while. No Cap.

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This edition has the following sections:

Adding Value: Debunking Cap Rate

Enjoy!

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Adding Value: Debunking Cap Rate

Once upon a time, I sat down for coffee with an investor, trying to pitch him to do a debt JV deal with us. The meeting went well, and as we discussed the deal, I gave him a lot of helpful information, such as how we would fund the project, the project’s cost, and what he could expect from the deal. Then, he asked, “What’s the cap rate for these types of deals?” I froze up. I had heard about the cap rate and pretended I knew what he was referring to, but deep down, I knew there was still internal confusion over what it meant. I then answered “8%” in an unsure, unconfident tone. In the end, this investor did not lend us his money. I don’t know if that was the reason, but I’m sure it wouldn’t hurt to give him a better, more confident answer about the Cap Rate.

Once upon a time was only a few months ago. Even with all of my experience in construction and real estate, Cap Rate was just not part of the jargon we used in our everyday deals. We have done primarily residential deals up to this point, where our most important metric is ROI: Return on Investment, not Cap Rate. As we become more sophisticated in our deals and look to raise more capital, adding jargon to our investment vocabulary to pitch to all kinds of investors and provide more information about our deals becomes essential. Raising money is a sales process. You’re selling your investment product, and in sales, you want to come equipped to handle all of your client’s concerns, which means speaking their language, even if it’s irrelevant to the deal.

After my experience with the investor, I was embarrassed and got caught up to speed on what the Cap Rate is. I want to write about that today so that if you get caught in a similar situation, you save yourself the confusion and potential embarrassment of not knowing.

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Not One, But Two Rates

There are actually two types of cap rates. The most common one is the Cap Rate you get by dividing your Net Operating Income by The Property Value. This Cap Rate gives you a good idea of the property’s performance relative to its price. On the other hand, the Market Cap Rate is a general reflection of market conditions. I was confused because I thought both were the same, but they were not. Let me break each of them down.

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Cap Rate

The Cap Rate, or capitalization rate, is a metric real estate investors use to evaluate a property's return on investment. To calculate it, you divide the property's Net Operating Income (NOI) by its current market value or purchase price. This percentage reveals the annual rate of return an investor can expect from the property based on its income relative to its value.

Here's a closer look:

1. Net Operating Income (NOI): This is the income generated by the property after deducting all expenses, such as property taxes, maintenance costs, insurance, and property management fees, from the rental income.

2. Property Value or Purchase Price: The current market value of the property or the price at which it was acquired. This value represents the initial investment in the property.

As a rule of thumb, the higher the cap rate, the higher your return on investment will generally be. A regular “good” cap rate will be above 8% depending on the market and the type of investment.

How about ROI?

One thing that always confused me was the difference between Cap Rate and ROI. When doing deals, we always consider ROI the most critical metric. The crucial difference is this: Cap Rate evaluates the property based on the purchase price, while ROI evaluates the property based on your investment. Here are the formulas for both

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Market Cap Rate

In contrast to the Cap Rate, which refers to an individual property, the Market Cap Rate focuses on the market conditions in which the property is located. It is somewhat of an indicator of what other investors in that market are willing to accept as a cap rate at that point in time. This metric is used more in commercial and multifamily real estate than in Residential real estate, where the Cap Rate or NOI is used more often.

Here's how it works: