Posts tagged: Real Estate Investing

Capitalization rates (cap rates for short) are one way to talk about estimated investment returns in real estate.  You’ll hear them mentioned a lot, such as “the cap rate is too low for this market”.

What is a Cap Rate?

The cap rate indicates the rough return on investment for a specific property at a specific point in time.

Net operating income (NOI for short) = how much a property makes after all expenses are paid except the mortgage (if applicable).

Market Value = how much the asset would sell for.

NOI/Market Value = Cap rate

Simple right?

Be careful – the NOI is calculated in different ways incorporating different expenses for different properties.  Market Value is what someone (including you) is willing to pay for it and will be different depending on different buyers’ situations (such as who can get better loan terms or have access to economies of scale to reduce costs after closing).

Ask which ones are included, walk through the assumptions or do your own due diligence.  You absolutely have the right to access the underwriting, expense and income information for a property before investing.  Keep in mind numbers can be adjusted a lot to support the point of whoever is running the calculations. The banks all get this, as an investor it is important you do too. If someone won’t share the data with you so you can check it, that’s a red flag.

What do I use a Cap Rate for?

There are a few general trends for cap rates:

• Properties perform better when they are bought at a high cap rate and sold at a low cap rate.  This typically involves adding value to the property and/or changing market conditions.
• Properties with lower risk tend to have lower cap rates than properties with higher risk.

The most useful thing is to compare properties in the same market.

Say a broker is offering a property at a 5 cap (that’s shorthand for a 5% capitalization rate). If other properties in the area are selling at a 6 or 6.5 cap, that’s a flag that either this property is much lower risk than the others OR the market value is higher than it can bear OR expenses have been creatively book kept to be very low.  Or a combination.  No matter which, it’s a flag to go dive deeper into the property finances.

For investors, cap rates can also raise a flag that underwriting may not be conservative.  If the cap rate at purchase is the same or greater than the assumed cap rate at sale, the underwriting is not conservative.  Banks generally assume an increase of 0.15/yr, so on a 5 yr hold 0.15*5 = 0.75 increase in cap rate.

Fun fact: the cap rate assumed at sale of a property is called the reversion Cap rate

Cliff Notes Questions for Investors

If you’re looking at a deal, here are a few Cap rate questions to ask the people who are underwriting it:

1. What is the current cap rate and reversion cap rate?
2. What are the cap rates for 3-4 similar properties in the same market?
3. How have the expenses used to calculate NOI changed over the past 3 years?
4. Will you walk me through your underwriting (or send me a link to it)?

If you have questions or want to learn more, set up a call and Join Club Clover.

When you think of real estate investing, what pops into your mind?

For most people just discovering the space, it’s buying a single family home similar to theirs then renting it out.  The rent covers any mortgage and repairs plus a bit more to provide some emergency funds and income to cover your time/effort.  Over time your home value goes up (equity), get some tax advantages (depreciation) and a bit of cash flow each month.

Equity, depreciation and cash flow are also the main drivers of income on larger properties and combine to make real estate one of the most common places for high income earners to place their money.  Real estate is an appreciating asset – it tends to go up in value over time so your money works to make more money.

What’s fun about RE is that you don’t have to own it alone.  In fact it’s a real team sport!

• Don’t want to be the one screening tenants or dealing with maintenance issues?  Then invest as a limited partner (LP) with a team you know, like and trust to operate the property for you.
• Don’t have a lot to buy the whole thing yourself yet?  Team up to buy a property (also called a syndication or joint venture)
• Looking to be part of the decisions to learn about running larger properties and a RE business? Join a general partner (GP) team to get hands-on experience alongside other team members.

Other team members can include brokers, property managers, maintenance vendors, tax accountant (CPA), lawyer, bookkeeper, the list keeps going.  The stronger your network, the more robust the business plan is and the faster your investment can grow.

Real estate has a strong track record of building long-term wealth through leveraging equity, depreciation and cash flow.  It’s not a get-rich quick scheme, it is a way to invest in the community that is strongly supported by government tax policies and the basic need for housing.  It’s a team sport where no matter your goals, you can get started relatively simply and grow from there.

Interested in learning more?  Contact us and we’d be happy to help you on the path to building your own luck.