Cap rate calculation
- Thread starter dplummer
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QUOTE (dplummer @ Nov 30 2010, 07:09 PM) Could someone please explain to me Cap Rates? How are they calculated? Whats good & whats not & what should be our goal. Thanking everyone in advance!
Doug
Speaking for myself, I anticipate half of the monthly rent to go towards expenses, not including monthly mortgage. Some individuals may call this pre-tax profit. For myself, I would take this monthly pre-tax profit, multiply by 12 to get the annual pre-tax profit and divide it by the purchase price to determine cap rate.
Assume $1000 per month in rent.
$500 per month after expenses
$500 x 12 months = $6000 pre-tax profit
Assume $60,000 purchase price
$6000/$60,000 = 10% cap rate
Again, this is only my perspective. Different people calculate it differently.
With regards to your second question, that is also very subjective. For myself, I would want around a 10% cap rate to be interested in investing in real estate.
Doug
Speaking for myself, I anticipate half of the monthly rent to go towards expenses, not including monthly mortgage. Some individuals may call this pre-tax profit. For myself, I would take this monthly pre-tax profit, multiply by 12 to get the annual pre-tax profit and divide it by the purchase price to determine cap rate.
Assume $1000 per month in rent.
$500 per month after expenses
$500 x 12 months = $6000 pre-tax profit
Assume $60,000 purchase price
$6000/$60,000 = 10% cap rate
Again, this is only my perspective. Different people calculate it differently.
With regards to your second question, that is also very subjective. For myself, I would want around a 10% cap rate to be interested in investing in real estate.
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QUOTE (dplummer @ Nov 30 2010, 05:09 PM)
Could someone please explain to me Cap Rates? How are they calculated? Whats good & whats not & what should be our goal. Thanking everyone in advance!
Doug
CAP rate is NOI divided over purchase price.
NOI is Net Operating Income, which is rent minus vacancies minus operating expenses (such as utilities, R&M, management fees, insurance, property taxes, ..)
CAP rates over 8% rarely exist in well functioning economies. They do exist in the US or in very small towns in Canada occasionally.
The higher the CAP rate the lower the price for the same NOI !
CAP rate is the inverse of the P/E ratio used in the stock market. So, a 16 P/E is about a 6.25% CAP rate. An 8% CAP rate is a P/E of 12.5 etc.
A single family house is usually sub 5% CAP rate .. or sub 4% in larger cities like Calgary, Vancouver or GTA !
The CAP rate should exceed by a margin the mortgage rate !
More here on CAP rate
Multi-Family Primer in May 2009 Issue of Canadian RE Magazine:
http://myreinspace.com/rein_members_only1/Members-Only_Discussion/81-10996-Multi-Family_Primer_-_May_2009_Issue.html
and its influencers to consider when buying an apartment building: http://myreinspace.com/public_forums/Real_Estate_Discussion/62-14548-Buy_vs_Build.html
Could someone please explain to me Cap Rates? How are they calculated? Whats good & whats not & what should be our goal. Thanking everyone in advance!
Doug
CAP rate is NOI divided over purchase price.
NOI is Net Operating Income, which is rent minus vacancies minus operating expenses (such as utilities, R&M, management fees, insurance, property taxes, ..)
CAP rates over 8% rarely exist in well functioning economies. They do exist in the US or in very small towns in Canada occasionally.
The higher the CAP rate the lower the price for the same NOI !
CAP rate is the inverse of the P/E ratio used in the stock market. So, a 16 P/E is about a 6.25% CAP rate. An 8% CAP rate is a P/E of 12.5 etc.
A single family house is usually sub 5% CAP rate .. or sub 4% in larger cities like Calgary, Vancouver or GTA !
The CAP rate should exceed by a margin the mortgage rate !
More here on CAP rate
Multi-Family Primer in May 2009 Issue of Canadian RE Magazine:
http://myreinspace.com/rein_members_only1/Members-Only_Discussion/81-10996-Multi-Family_Primer_-_May_2009_Issue.html
and its influencers to consider when buying an apartment building: http://myreinspace.com/public_forums/Real_Estate_Discussion/62-14548-Buy_vs_Build.html
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QUOTE (Rickson9 @ Nov 30 2010, 05:58 PM) Speaking for myself, I anticipate half of the monthly rent to go towards expenses, not including monthly mortgage.
Rickson has correctly demonstrated the method of calculating the capitalization rate. You take the yearly operating income calculated as yearly rent minus yearly expenses, and divide by the purchase price.
I don`t understand the method of using a rule of thumb for determining expenses. While using 50% is better than using 25% or 75%, it isn`t more accurate than making a concrete estimate of each individual expense based on past history for the building and experience with similar assets.
Making a good guess at something isn`t better than making an accurate estimate based on facts and analysis.
After all, the expenses of the building are determined by the tenants, the building, and the management. How much you pay for your utilities, maintenance, etc, aren`t determined by its rental rate. If rent control and long term tenants mean your tenants are paying you only $500 per month, your expenses might still be $500 per month, or 100%. If a better location means you get $1500 per month, there is no reason the expenses would be higher, meaning they would be 33% of rent.
michael
Rickson has correctly demonstrated the method of calculating the capitalization rate. You take the yearly operating income calculated as yearly rent minus yearly expenses, and divide by the purchase price.
I don`t understand the method of using a rule of thumb for determining expenses. While using 50% is better than using 25% or 75%, it isn`t more accurate than making a concrete estimate of each individual expense based on past history for the building and experience with similar assets.
Making a good guess at something isn`t better than making an accurate estimate based on facts and analysis.
After all, the expenses of the building are determined by the tenants, the building, and the management. How much you pay for your utilities, maintenance, etc, aren`t determined by its rental rate. If rent control and long term tenants mean your tenants are paying you only $500 per month, your expenses might still be $500 per month, or 100%. If a better location means you get $1500 per month, there is no reason the expenses would be higher, meaning they would be 33% of rent.
michael
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QUOTE (bizaro86 @ Nov 30 2010, 08:15 PM) ..
I don`t understand the method of using a rule of thumb for determining expenses. ..
50% is a good rule of thumb .. a starting estimate !
Many expenses are NOT known precisely upfront in teh time available (say 2 weeks for condition removal) and also change over time without your control such as: property taxes, utilities, property management fees, insurance or condo fees.
of course, the more due diligence you can do the better !
Therefore, the CAP rate is always just an estimate too !
I don`t understand the method of using a rule of thumb for determining expenses. ..
50% is a good rule of thumb .. a starting estimate !
Many expenses are NOT known precisely upfront in teh time available (say 2 weeks for condition removal) and also change over time without your control such as: property taxes, utilities, property management fees, insurance or condo fees.
of course, the more due diligence you can do the better !
Therefore, the CAP rate is always just an estimate too !
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Cap Rate is also calculated before debt service and taxes, or on the NOI, as Thomas points out.
Unless we are the actual owner of a property, we do not know the exact operating expenses. Therefore, we have to guess in the dark. AND, just because a seller tells you expenses are $xxx, that does not mean they are $xxx. More often than not, they are greater than the $$$ provided by a seller. How many sellers build in a management or vacancy figure, as examples?
For a single family home, a 50% expense ratio is probably reasonable. As the number of units grows, that ratio will drop. Larger multi-family properties can be anywhere from 30% to 50%, depending on a lot of factors.
In each case, we should use our own numbers and recalculate the NOI based on our knowledge, and not use the NOI presented by a seller.
These conversations have been describing how a Cap Rate is calculated. The conversation about how to pick a Cap Rate in order to calculate a purchase price is very different. I will say simply that the market determines the current cap rate. Thomas touched on that. When considering a property that uses the income approach to set value, we need to know what the current Cap Rate in that area is. The best way to learn that is through an ICI Realtor or appraiser.
Unless we are the actual owner of a property, we do not know the exact operating expenses. Therefore, we have to guess in the dark. AND, just because a seller tells you expenses are $xxx, that does not mean they are $xxx. More often than not, they are greater than the $$$ provided by a seller. How many sellers build in a management or vacancy figure, as examples?
For a single family home, a 50% expense ratio is probably reasonable. As the number of units grows, that ratio will drop. Larger multi-family properties can be anywhere from 30% to 50%, depending on a lot of factors.
In each case, we should use our own numbers and recalculate the NOI based on our knowledge, and not use the NOI presented by a seller.
These conversations have been describing how a Cap Rate is calculated. The conversation about how to pick a Cap Rate in order to calculate a purchase price is very different. I will say simply that the market determines the current cap rate. Thomas touched on that. When considering a property that uses the income approach to set value, we need to know what the current Cap Rate in that area is. The best way to learn that is through an ICI Realtor or appraiser.
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QUOTE (ThomasBeyer @ Dec 1 2010, 10:54 AM) 50% is a good rule of thumb .. a starting estimate !
Many expenses are NOT known precisely upfront in teh time available (say 2 weeks for condition removal) and also change over time without your control such as: property taxes, utilities, property management fees, insurance or condo fees.
of course, the more due diligence you can do the better !
Therefore, the CAP rate is always just an estimate too !
Certainly using 50% is better than blindly trusting the numbers the seller`s numbers, but I would hesitate to buy property based on a rule of thumb. While it can be helpful, why not continue with due diligence to make a better estimate. Maybe it should be 45% for one property and 55% for another, which changes their value relative to each other.
Michael
Many expenses are NOT known precisely upfront in teh time available (say 2 weeks for condition removal) and also change over time without your control such as: property taxes, utilities, property management fees, insurance or condo fees.
of course, the more due diligence you can do the better !
Therefore, the CAP rate is always just an estimate too !
Certainly using 50% is better than blindly trusting the numbers the seller`s numbers, but I would hesitate to buy property based on a rule of thumb. While it can be helpful, why not continue with due diligence to make a better estimate. Maybe it should be 45% for one property and 55% for another, which changes their value relative to each other.
Michael