Investor Dan

How does one determine a cap rate value if they are paying cash for an investmet property?
Thanks,
Dogaroosker

The question would be better int he commercial forum. Cap rate is not use much for residential. Cap rate is very important with commercial.

Coming back to the question…

If you are paying cash or if you are getting loan, the cap rate will be the same. They are not related in most any sense. If the cap rate is the same and the NOI is the same, the value for a building with debt vs. all cash will be the same. An investor might want a discount if they are paying all cash. That does not mean they value is less, just that the investor wants a bargain (buying below the market value).

The cap rate in the area for a specific type of building will be what others are using for that type of building. You compute the NOI and then you divide the NOI by the cap rate for the area. In other words the market determines the cap rate for a type of building and each building is priced relative to the prevailing rate.

On a more macro level the cap rate is relative to the interest rate or yield on alternative investments. As most yields are pegged relative to the US Treasury yield, you could argue that the Fed indirectly sets the cap rate for the USA. Indirect but a clear connection.

[QUOTE=dogaroosker;884604]How does one determine a cap rate value if they are paying cash for an investmet property?
Thanks,
Dogaroosker[/QUOTE]

Net operating income divided by the purchase price equals cap rate.

If your apartments make 100k per year and you paid 1 million you have a 10% cap rate.

[QUOTE=AmotoXracer;884616]Net operating income divided by the purchase price equals cap rate.

If your apartments make 100k per year and you paid 1 million you have a 10% cap rate.[/QUOTE]

The equation does work as noted above. I would not say that the number produced is necessarily correct. If the property is priced above or below what it should be, the cap rate will be off. Just because some is asking a specific price does not mean the price is correct. Hence the cap rate computed from an asking price is proportionally right or wrong.

There will be a cap rate that represents the average for the market. Similar to how comparables can be used to determine what the trend is in the market vs. what any one property is priced at.

BTW - The NOI can vary based on what people put in or leave out. NOI should include operating expenses and there is a lot of fudge room if people want to push the NOI.

Ray Alcorn has a few comments on this. I remember a recent post in the commercial board where Ray highlights this.

[QUOTE=John_Corey;884619]The equation does work as noted above. I would not say that the number produced is necessarily correct. If the property is priced above or below what it should be, the cap rate will be off. Just because some is asking a specific price does not mean the price is correct. Hence the cap rate computed from an asking price is proportionally right or wrong.

There will be a cap rate that represents the average for the market. Similar to how comparables can be used to determine what the trend is in the market vs. what any one property is priced at. [/QUOTE]

Frequently, I cant tell what point your trying to make, or even if there is one.
This is one of those times.
How can a cap rate be off if a property is mispriced ?
Who determines the proper “price” with which to determine cap rate ?

AmotoRacer,

You wrote:

Net operating income divided by the purchase price equals cap rate.

If the sale price price is high or low the cap rate is ‘wrong’. I agree the equation is as you wrote it. I just do not agree that the equation really addresses the spirit of what was being asked.

if the NOI is wrong the cap rate will also be wrong. In other words, the equation will not produce ‘the’ cap rate as much as it produces a value for one transaction where the important details are hidden from most external observers. It would be a cap rate but it could easily be an invalid conclusion.

What is better?

Agents dealing in a type of commercial property in an area will know the prevailing cap rate for the specific type of property. That is the cap rate that really should be used to compare similar properties in the area. Active investors in an area will also know what sort of cap rates make sense in the current market.

Warning: What people are doing when they calculate the NOI can muddle the waters even if different people use the same cap rate. Ray Alcorn wrote a piece explaining why various NOIs will be produced by different people when looking at the same property.

Maybe a tangent too far for some: Cap rates move relative to the yields in alternative investments (non property). Bonds being the biggest driver if you want the theory. The same principal that causes all yield investment to be based relative to risk free government bonds.

[QUOTE=John_Corey;884627]AmotoRacer,
If the sale price price is high or low the cap rate is ‘wrong’. I agree the equation is as you wrote it. I just do not agree that the equation really addresses the spirit of what was being asked.[/QUOTE]

Well, at least you said you agree with the equation…

Cap Rate if cash

I want to thank you for your discussion. It has made clear exactly what the precise formula for determining a cap rate. Understanding, however, one must be aware a NOI can be munipulated and (serious Due Dilligence is required, if possible), the negotiated purchase price may alter the cap rate, and an Agent should know the prevailing cap rate in the area for the type of property considered.
Thanks Again,
Dogaroosker

[QUOTE=John_Corey;884627]AmotoRacer,

You wrote:

If the sale price price is high or low the cap rate is ‘wrong’.

if the NOI is wrong the cap rate will also be wrong. .[/QUOTE]

I dont agree with the 1st statement. A better statement is that the cap rate would be out of step with the market cap rate (which you correctly pointed out DOES exist.) The cap rate is used to evaluate different properties, say a 20 unit apt bldg vs. a strip mall… or 20U vs 40U.

If the sales price is high or low, the cap rate is NOT wrong. The cap points out that the price is low or high. (So really it is the PRICE that is “wrong”.) Then the follow up question is: why. (Condition? Location? Desperation? Amenities?)

One other thing that is often left out of cap rate analysis/explanation is that cap rates also encompass other factors. Most often risk but also “hoped for apprecation”. Perceived risk is why MHPs will tend to have cap rates in the higher ranges and “appreciation” is why apartments in major cities in CA will have cap rates in the lower ranges. So while a high cap rate is better, it may also signify more perceived risk. Again, ask WHY is the cap rate so high? (Poor condition? High current vacancy? etc)

The 2nd point is well made and amplifies the point that the NOI needs to be “cross-examined” with a lot of dilligence.

What costs are being left out (vacancy, (deferred) maintenance, capital expenditure set asides, lawn care etc.)? Is the owner doing these himself? Budget for them anyway. Is he doing his own management? Budget for that too (time IS money).

Is the NOI pro-forma? Then it’s toilet paper. Get ACTUAL numbers.

Ask for bills from providers and tax returns.

Picking up from Mark’s post…

There are different market cap rates for different markets and that can me the same geography yet different asset types. MHP vs. A class office buildings. Apartments vs. strip retail centers. How you own and operate the various properties could be a clue as to why they have different risks and different cap rates.