Many investors, not us, base their purchase decision on the cap rate. As I explained in another lesson, NOI-Net Operating Income, the cap rate is a quasi-figure because it must depend on purchase price to get its number. Many times, the purchase price is a subjective number. Either a broker or the seller sets the purchase price.
When it comes to a cap rate, there are two different types of cap rate, a normal cap rate that is entirely a subjective number. The other is a market cap rate. The big brokerage firms such as Sperry Van Ness, CBRE, and Marcus & Millichap, set the market cap rate. They have analysts that gather data from recent sales to decide the figure. It is not an entirely objective figure but not so much subjective either. Regardless, it is a respected figure. We use it to analyze our potential transactions.
Each market should have three different market cap rates differ by building class. A Class usually is much lower than B Class. B Class is much smaller than C Class. We don’t care about D Class because we will never deal with D Class buildings. D Class are usually in ghetto and war zones. We don’t normally deal with A Class as they don’t produce much profit. A Class has much more room to go down in price as the building gets old. Our main acquisition is in B Class and C Class buildings.
For example, the cap rates for Multifamily properties in Los Angeles were 2.62% for A Class, 5.75% for B Class, and 7.31% for C Class. In a real-life practice, A Class is 2.5% to 5%; B Class is 4-8%; C Class is 6-12%
Another outside factor that can move cap rate is the interest rate. If the interest rate moves higher, the cap rate moves higher as well, not necessarily at the same rate. The reason is that when the interest rate goes up, mortgage payment goes up. That effectively limits the potential buyer. Therefore, analysts move the cap rate a bit higher to make the market more efficient.
We acquire property on our price term, but we use a market cap when we sell. That is now becoming a margin, a profit margin. When we do the analysis, we use a factor of 1.7 or more margin. If the market cap rate is 10%, we will purchase at minimum 11.7% cap rate. This ensures that we can get close to even if we turn around and sell it immediately. This is the way we use cap rate in our analysis. You can stop read here if you know about cap rate. Another basic explanation of cap rate follows after this paragraph.
A cap rate is simply a formula. It’s the ratio of a rental property’s net operating income to its purchase price (including any upfront repairs):
Importantly, the cap rate formula does NOT include any mortgage expenses. As you can see in the formula for net operating income below, the expenses do not include a mortgage or interest payment.
Excluding debt is part of why a cap rate is so useful. The formula is focused on the property alone and not the financing used to buy the property.
Every investor uses a different combination of down payment and financing. So, a cap rate assumes a property is bought for cash without leverage.
This assumption lets you focus on the merits of the property’s financials instead of being distracted by debt. It also enables you to compare the risk of one property or market to another.
