How to Analyze Real Estate Rental Properties: Capitalization Rate Explained

When you're analyzing a deal, there are a lot of metrics that an investor could use. One of the most frequently used metrics is the cap rate. Let's get into that. So you're a real estate investor trying to find the very best next deal, capitalize on the new changing market. The one term you're going to frequently hear over and over and over again is cap rate or capitalization rate. Why is it so important and why does it matter to you? Learning about cap rate is critically important. Whether you're an investor, you're a realtor, you're an appraiser, you're a broker, whether you're representing the buyer or the seller, this is a commonly used benchmark. And it's really important that you know how to use it, how to come up with it, because if you don't, someone else will, and they're going to use it against you. Today, we're going to do a deep dive on capitalization rate, what it means, how to calculate it, what's included, what's not included, the benefits, the cons, and more importantly, what you could do to play around with the cap rate to improve value, add value, and more importantly, add equity to your bottom line. The definition for cap rate is the rate of return based on the purchase price of a property. So all it is is a ratio. So a lot of people like to complicate it. I know that there's a lot of residential realtors out there that would like to get into income producing properties, but cap rate, capitalization rate, yields rate of return sometimes scares people, but I'm going to show you today. It's pretty simple. It's something that you could take away after watching my video and put it to use immediately. Cap rate is a rate of return that a property will give you based on its current market value. Okay. In the scenario that I'm going to use today, I'm going to look at a fourplex. That's a four unit building. I'm going to assume that at this fourplex, the property is making $66,000 a year. Okay? So I take all four rents. This is what's known as the gross income. That's where we start. We deduct what's known as expenses. In this case, it's very common for a four unit building to have 30% expenses. So I'm going to subtract the expenses. Let me show you exactly what's included and what's not included in the operating expense. Within this 30%, I've come up with an acronym trim up. Okay. This is probably the easiest way to figure out what's included, what's not included. Okay. So from the very top, taxes. When you buy a property, you're going to be paying property taxes on the purchase price of the property. So that's going to be always be included. Now, when you buy a property, it's off of the new price, not the past price. So when we're looking at calculating cap rate, please don't use the numbers of the prior sale, the person selling it to you. You're going to have your own taxes on the property. You're going to have repairs. You're going to have insurance. Next is management. This would be, if you have a property manager, you're going to have utilities. So this would be water and electric bill, a gas bill. Sometimes it might be water. Sometimes you have no utilities. And the last one's payroll. The only reason I'm including this is that if you're watching this video, but you're buying something that's much larger, 16 units, 20 units and above, you're going to have payroll. This is something I call trim up. So again, taxes, repairs, insurance, management, utilities, and payroll. This is what's included in this operational expense. Okay. You're going to notice that one item that you're probably expecting to see here, but you don't is mortgage. That's correct. Mortgage will never be included in the operational expense of the property. Reason being is my mortgage might be different than your mortgage. My down payment, the amount that I borrow will be different. So the purpose of cap rate is that we could compare one investment to another similar investment. And if we know how to use capital cap rate, we could quickly assess which deal is better. So that was the purpose of being able to compare apples to apples in this type of situation. So again, taxes, repairs, insurance, management, utilities, payroll. It is possible that in some cases you don't have management. It's possible that you don't have utilities or payroll, but overall, this is what you're going to have. This is what's called the operational expense. It's important that you know that. Okay. Now that we've figured that out, we're going to subtract the 30%, which is the operational expense from the gross revenue. We're going to subtract our expenses and we end up with 46,200. This is a very important number because this is what we know as the net operating income. In order to calculate cap rate, we always need, or we need to find out what the net operating income. So when we think of cap rate, it's very important that we're not working off of the gross number. The gross number is used to figure out a different benchmark. So I do want you to check out our prior video. And that's where we talk about the gross rent multiplier. And in the gross rent multiplier, we're only focused on the gross rent. In this case, we're subtracting the operational expenses and we're ending up with the NOI. Let me take you into a really nice formula that will help you understand how to calculate this. It's known as ERV. Uncle ERV. Okay. So you could see ERV. This is critical because earlier on, when I gave you the definition that cap rate, it's simply a ratio between net operating income and the value of the property. That's all a cap rate is. Now that you know how to arrive at the net operating income, this is what makes up the I in the ERV formula. So this is NOI. This will always go at the top. Okay. The R stands for rate, cap rate. The V is valuation or value. Okay. So you have NOI, not gross rent. Okay. This is subtracting out the operational expense. We have NOI, we have cap rate, and we have value. And what this is supposed to mean is if I have the NOI and if I divide it by value, I'm going to come up with a cap rate and vice versa. Sometimes if you're an investor and you want to buy in a specific area and you want a 6% cap rate, I'm just using that as an example. You could use the NOI and the rates, the cap rate to come up with value. So you could use them interchangeably to come up with the value that you need. Using this example, we have a $46,200 NOI. And in this case, I'm just making the assumption that the property is worth $770,000. I make some simple division and I come up with a 6% cap rate. So you could see how we took this one property, took out the operational expense, came up with the net operating income, divided it by the market value, and we came up with a cap rate. I'm going to redo this example, but this time we don't know the value, but we know the cap rate. I'm going to take the same NOI because the NOI hasn't changed for the property. That's going to be the same. This time, I don't know the value, but I know that I want a 6% cap. We make this division and guess what? We come up with $770,000. No matter whether I know the cap rate or I know the value, I could come up with the same number, which is important. Now that you know what cap rate means, the formula for coming up with the operation expense, what net operating income means, and the actual formula for the cap rate, IRV, I want you to start playing around with that because this is information that you could go use on any income producing property. Typically, if you were to talk to me about cap rates, I'm going to think multiple dwellings. Every now and then I see people use cap rate for a condo or a house. I discourage that only because properties that are single family home or condos are not traded by investors based on cap rate. It's not to say that you can't apply it. It's just, I don't believe that it's commonly used. So it may be difficult to come up with a cap rate on that type of unit, but whether it's two, three, four units and above, cap rates will be something that you could calculate on your own. And again, to get good, you need practice and I definitely encourage it. Now, in the scenario that I used earlier, it was a 6% cap. Common question I receive is what's a good cap rate? And the best answer I could give you is it all depends on location. So real estate's location, location, location. Okay. And that applies to cap rate as well. Because if you go to certain parts out of state of California, a cap rate of eight, nine to 10% might be somewhat normal. In Southern California, we're not seeing anything at an eight cap, seven cap would be rare. So it all depends on where you're at. The one thing I said is that it's market derived. I can't make it up. I can't just walk into an area and say, the cap rate should be this. I need to back it up. So where we learned this is from appraisers. So if you were to ask an appraiser, Hey, what's the cap rate in a specific region or a specific area or a neighborhood, they're going to go find past sales, recent past sales. They're going to work backwards and try to figure out what is the cap rate on all the sales. And that's exactly what we do as real estate brokers as well. So we could figure out in this part of Long Beach, the cap rate is 4.5%. That's the rate of return that an investor would receive if they buy the property cash. Is that a good return? It all depends on what the market gives you. Let me give you guys an example. In the world of real estate, what you're looking for is a higher cap rate because a higher cap rate means a better rate of return. And it exactly means a lower purchase price. So the better the cap rate, the lower the purchase price. That means you win. If I'm looking in a place like Long Beach and a property is a 7% cap, but I know that the neighborhood cap rate is 5.5. Okay. This is a good situation. That means that on day one, I'm getting into equity because I'm getting a better return than other similar property. If I was to buy something at a 5.5 cap rate and the market is 5.5, I would simply say that I'm buying the cap rate at market. That's not a bad thing at all. What we don't want is to go in reverse, meaning people, investors in a specific market are wanting to receive 5.5 cap rate. And for some you buy at a 4. Well, in this scenario, I would say you're behind. Okay. There's a loss there. There's no reason why you would buy something that's at a lower cap rate than what the market should be. Back to my main point that as an investor, what you're trying to do is get the highest cap rate as possible in most cases. Okay. Because again, the higher the cap rate, the lower the price. I'm going to give you an example so you could see how that quickly changes. My original example was my NOI of $46,200. And at a 6% cap, the value was $770,000. Again, this is the value that you buy the property at. Okay. Now what happens as we lower the cap rate in this case, instead of selling a property or buying a property at a 6% cap, which gives me this price. Let's just say that you're only able to buy it at a 5% cap. This gives me a value of $924,000. So this is what I want to show you is that the lower the cap, the higher the price. I'm going to give you one more example. So you really get an idea of what's happening to value when we're talking about cap rates. So again, I've lowered the cap rate one more time. Now, this one would just be by half of a percent, but let me show you what this does to value. In every scenario, I've lowered the price. In every scenario, the value has gone up. Okay. If you're a buyer, it's really important to know what the going cap rate is in your region. Again, if you're working with us here in Southern California, we're helping you buy something. We got your back. We know what cap rates should be in most cities. And if we don't, we go do the research and say, this is what the going rate is in that area. And this is what you're paying for yours. Okay. Cause this is, this really answers your question. Am I getting a good deal or not? And this is one of the measurements that allows us to get there. So good example to give you an idea that as the cap rate goes up, the value goes down and in reverse, as the cap rate goes down, the value goes up. Okay. Everyone quick sidebar. For those of you who found the cap rate and the formula a little too complicated, not a problem. We've made it really simple. We've created a custom calculator just for you, the real estate investor. So whether you understand the cap rate or not, all you need is the income, the expense ratio, and the cap rate will be calculated by our webpage. It's free for you to use. Check it out. The link is below. The next step that I want to show you is how adding value creates more income to your property. And what I mean is after you buy a property, you've made some improvements. Maybe you've painted the building, you've done some landscaping, you've changed out security fixtures, you've added parking, you've added laundry. And let's just say that, that same fourplex, you were able to increase each of the units by a hundred dollars. Okay. So that's $400 a month that you're now going to be receiving because you made improvements, right? On an annual basis, it's $4,800 a year. Okay. This is something really important. A lot of people would believe that if you are able to receive an additional $400 a month, that you've increased the value of the property by $4,800 a year. I could see how one would think that, but what I want to show you is the cap rate. You could use it again. And this time, what I want you to do is when you're looking at a property and you do change the income, just take that income. Let's put it on a cap rate and see what value you really did bump the property up by. Let me show you an example. So right now at the end of year one, we're now receiving an additional $4,800 than before. We're going to subtract the 30% because that's our operating expenses. In this 30%, we're going to subtract $1,440 and we're going to come up with $3,360. So this would be, so that you could follow along, this would be NOI of the new increased rate. Okay. This is not the overall gross, but I just trying to teach you guys a quick lesson here. So now because we've made improvements, we've made the property better. We're now getting a higher rent. Our NOI of those improvements is $3,360. I take this amount, take my herb formula, right? And now let's see what this really does in terms of value. Let's just say that 6% is the growing cap rate in this area. So what I want to show you is, is that this increased income that the property is now receiving relates to a value of $56,000. My friends, this is equity growth. Okay. That is equity growth. So by making some smart strategic management improvements, we've raised the rent by $4,800. And after you apply this, look what's happening. Look what this increase is relating to this much and increased value. So if you remember, we bought the property for $770,000. And when we're adding equity to the property, this is what we could add to it now, $56,000. That is how we build wealth. That is what savvy investors are doing over and over and over again. Here at Sage Real Estate, we've developed the 6-2-1 formula. And the six is the six ways that we're going to evaluate real estate values. And so cap rate is one of those six. Now in the world of commercial real estate, for some reason, people give cap rates so much weight. And I'm not sure why, but over and over, people just want to know one thing and one thing only. What's the cap rate? Now, I want to know the cap rate, but I want to know the other five measurements. So what is it about the cap rate that I don't like? Well, here's what I don't like. The cap rate is a snapshot of the property for a 12-month period. We know in the world of real estate, this is a long game. So the longer we own it, the better we're going to be. Now, the cap rate is a cap rate for a one-year holding. That's the limitation that I don't like so much about the cap rate. If we're going to own it for 12 years, we're only looking at the income during that first 12 months. But again, if you're a savvy investor, you know how to manage a building well, you could improve the income. Well, year two is not the income of year one. So that's one limitation. The other limitation that I see is that expenses could vary from building to building. And depending on the seller and the real estate broker, you may not be seeing the full picture. So expenses could be a little bit manipulated by the selling agent or the seller at some time. So that's why cap rate is one measurement and it's not the end-all be-all. Here at Sage Real Estate, it is our mission to teach folks how to build wealth through real estate ownership. And one of the ways to do so is learning how to analyze a good deal. And so we've created the custom 6-2-1 formula. On our prior video, we covered step one, which is the gross rent multiplier. This is the cap rate and we have the rest of the benchmarks coming really soon. So make sure to like, comment, and subscribe. If you have any questions, please comment below, share with a friend. That's all for now.