How to Calculate Cap Rate

published Wednesday, February 23rd, 2011 at 8:02 pm by Nick Graff, CCIM

If you are investing in apartment buildings, it is essential that you learn how to calculate cap rate. The majority of industry professionals like brokers, appraisers, and other investors use the cap rate analysis to assess their opinion of value.

To learn more about investing in commercial Real Estate, click here to see the fastest way to wealth that I know of.

While most investors look at cash on cash return when comparing investment alternatives, multi-family investors look at cap rate. Cap rate is simply the cash on cash return that an income property provides as if the property was purchased all cash. In other words, if you have $1MM to invest and you want to look at all the places you could invest that money, you would use the cap rate to tell you what your cash on cash return would be. Cap rate is similar to the “price to earnings ratio” in the stock market.

More commonly, cap rate is used to compare values of properties in a given market. Instead of looking at other houses in the area to assess value like in residential; in commercial, industry experts assess the financial performance of one building compared to the other buildings in the market and use their cash on cash return to find how much an investor would most likely be willing to pay.

If you don’t know how to calculate cap rate, don’t worry, I am going to show you now:
There are a couple pieces of the information puzzle you will need to find the answer to the true cap rate.
First, you will need to know how much the net operating income of the building is.

To get that, find out how much the owner is collecting in revenue. This would include laundry income, cell tower space, billboard leases, parking leases, garage leases, and of course, rental income.

Once you know the total gross collected income for the previous 12 months, then find out the previous 12 months worth of expenses. This would include fixed expenses like taxes, insurance, etc. and revolving expenses like gas, electric, management, water, repairs, maintenance, etc. Some people stop there. Most appraisers do not. They also include projections to cover vacancies, credit loss, replacement reserves, etc.

When you have the income and expenses for the previous 12 months of operations, all you do is subtract the expenses from the income. If you had $100,000 in income and $40,000 in expenses, you would be left with a net operating income of $60,000.

Now that you have the net operating income, you can simply divide that number by the price of the property to get your cap rate. If you had a $60,000 NOI and the owner was asking $1,000,000 for the property, you would get a cap rate of 6% (.06).

Now that you know your cap rate, make sure that it is in line with the market. The higher the cap rate, the more cash flow it produces. On the contrary, the lower the cap rate, the less cash flow.
This means that the property you are looking at is too expensive if the cap rate is too low. If the buildings in your area say your prospective purchase is worth a 6 cap, and the owner is asking a 5 cap, then you know it is over priced. If they are asking a 7 cap, you may have found a bargain.

To learn more about investing in commercial Real Estate, click here to see the fastest way to wealth that I know of.
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Nick Graff, CCIM is an experienced commercial broker who specializes in finding apartment building deals in America for cash buyers around the world. If you or anyone you know would like priority access to his deals, visit http://www.apartmentbuildingbargains.com .

7 Ways To Find Great Deals on Multi Family Buildings For Sale

By Nick Graff, CCIM

1. CCIM.com – This is the most under-utilized and valuable service that I am aware of. It is free and it contains real nuggets of gold. Of course, you can go to http://www.ccim.com and find all kinds of resources about investing in commercial real estate, but the gold is found at http://findaprofessional.ccim.com/search. At that little-known link, you now have access to some of the best, most experienced commercial brokers in the market you are interested in and the property type you are looking for. Treat this information with respect because if you can nourish the relationships that you have the ability to develop, this may be the only resource you need to find great deals on multi family buildings for sale.

2. Evictions Court – If you own any rental property and have been through an eviction, you have seen a concentrated group of frustrated landlords. They are not ALWAYS looking to sell, but a good chunk of them are. Just go down to your county courthouse and find the days and times of evictions courts. Get in the habit of going to all of them. Just watch your first couple times and see the frustration. Introduce yourself and let them know you are interested in buying multi family buildings.

3. Canvassing – This is usually the best way to start finding buildings in your area. Canvassing is driving up and down the streets and neighborhoods where the multi family buildings in your area exist. You are not necessarily looking for buildings for sale. The main point is to get to know your market, know the buildings, and actually find the owner out at the property. You can uncover some golden nuggets if you are dressed well but not overkill, have a good conversation, and are good with followup. This is also a great way to build your database.

4. LoopNet – Everyone goes to loopnet first to find deals. This is a great place to get started because you can learn how to analyze deals. Once you are past that stage, the main reason I would use loopnet is to source multi family brokers. If you look for multi family for sale in your market, pull out all of the listings and call all of them. Don’t do it just to get a deal, do it to build relationships. Keep in mind that commercial brokers on loopnet are probably getting a lot of tire-kicker buyers. If you are qualified, then show them that.

5. Direct Mail – Sending letters to building owners is probably the fastest way to weed through all of the potential riff-raff and get straight to a good deal. This really depends on your budget. If you have at least a few hundred bucks a month, you can go to the county courthouse, record all of the 5 unit and up multi family buildings in your market and send a series of letters to them. You will get calls and most of them will be owners who are trying to get more than their property is worth. Expect to get 1 good deal from every 100 owners you talk to.

6. Ads - Of course, putting an ad in the local newspaper is one way to get leads. The bad news is that newspaper readership is way down because of the internet. The good news is that most investors, whether buying or selling, do look at their local paper still. Although, it is not the best way to spend your money, it is good if you have a sizable budget. Also, you can advertise using Adwords on Google if you know of some good keywords that owners may be typing in.

7. Banks – Forming key relationships with asset managers in your local banks can be a great source of great deals. If you can show that you are serious and qualified, you can work your way into getting direct access to OREO and pre-foreclosure assets. If you are buying distressed properties or distressed commercial notes, this is a must.

5 Factors You Must Consider When Investing in Apartment Buildings

By Phil Wazonek April 3, 2012

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When I am considering investing in an apartment building, the ultimate question in my mind is: Is this a good deal? Sounds obvious, but I am amazed at how many investors don’t know how to recognize a good deal. Learning to recognize a good deal takes research, education, and experience.
Here are the five most important issues to consider when investing in apartment buildings.

1. Cash Flow

Will this property cash flow? This is the most important issue to consider, and it depends on a lot of factors, including:

• Strength of the local rental market (vacancy and delinquency)

• Type of market you are buying into (C class buildings usually have more tenant turnover and higher repairs and maintenance than A or B class buildings)

• Interest rate on your financing (is it conventional financing or a hard money loan?)

• Size of your down payment

All of these factors considered, ask yourself, “Will this realistically provide income for me?” Also, ask the question, “How will this property cash flow compared to other potential properties?”
For example, a $150,000 house that rents for $1,000/month has a better income potential than a $300,000 house that rents for $1,600/month. A four-unit building that costs $400,000 may bring in $3,000/month in the same neighborhood.

Buying in the right neighborhoods and in the right stage of a real estate cycle will result in appreciation and profit.

Whether the property will provide income to you begs the question of whether income is important to you. Is it? Do you earn other income that would allow you to spend more of the income refurbishing the building? Do you need more income now, or is future equity growth more important?
There are no right answers to these questions, but they are factors to consider when looking at a potential purchase.

2. Leverage

Leverage is important in investing because the less cash you put down on each property, the more properties you can buy. If the properties go up in value, your rate of return goes up exponentially. However, if the properties go down in value, and you have a lot of debt on the property, the result can be negative cash flow.
Negative cash flow can be either “bad” or “good.” The “good” kind is short-term and makes you money.
For example, all the foreclosures we’ve bought had high vacancies and needed rehab work. So we needed the financial capacity to get through the negative cash flow until we could stabilize the property and create a very good positive cash flow. Then we had options to either sell the property or to refinance and pull out most of our money.

“Nothing down” investing is very attractive for the high-leverage investor, but should be approached with caution. If you are a long-term player, leverage will generally work in your favor if the markets in which you invest appreciate in the long run and your income from the properties can pay for most of the monthly debt service.

3. Equity

Does the property you are purchasing have equity or can you create equity? Equity can take a number of forms, such as:

• Discounted price

• Fixer upper – “upside” potential

• Rezoning opportunity

• Poor management

• Foreclosure

There are many ways to create equity, but buying into equity is your best bet. Find a motivated seller who wants out of his property and is willing to give up his equity for less than full value. Or buy a property that needs work that can be done for 50 cents on the dollar or less. In other words, if the property needs $10,000 in work, make sure you get a $20,000 discount on the price or better.

4. Appreciation

Buying in the right neighborhoods and in the right stage of a real estate cycle will result in appreciation and profit. However, timing a real estate cycle is difficult and is very speculative. If you buy properties without equity or cash flow solely for short-term appreciation, you are engaging in a risky investment.
Buying for moderate long-term (10 to 20 years) appreciation is safer and easier. Look at long-term neighborhood and city-wide trends to pick areas that will hold their values and grow at an average 5 to 7% pace. Combine this tactic with reasonable cash flow and buying into equity, and you will be a smart investor.

5. Risk

Risk is a consideration that too few investors consider. Ask yourself, “What if my assumptions are wrong?” In other words, do you have a “Plan B”?

If you bought for appreciation and the property did not appreciate in value, can you rent for positive cash flow? If you buy with an adjustable rate loan and the rates go up, will this put you out of business?
If you have a few vacancies, can you handle the negative cash flow, or will it break the bank for you? Expect the best, but prepare for the worst.

Warning Signs of a Bad Deal

The Numbers Don’t Add Up. You’re in this game because you want to make money. If the numbers don’t add up, and the seller won’t drop the price or give you better terms, move on.

Missing Numbers. If the seller can’t provide you with the year-to-date profit and loss statements, plus the actual numbers from the previous two years, move on to another deal.

Made-up Numbers. Pro forma numbers are pure guesswork. They may be educated guesswork, but they are still a projection. Lenders won’t give these made-up numbers any weight and neither should you. This is where your experience plays a big role. After a while, you will quickly be able to figure out “who is blowing smoke” or if the numbers make sense.

Troubled Property. A property may look good on paper–the numbers are real and they add up. But a site visit paints a different picture. Perhaps it needs major repairs because the seller has been deferring the maintenance, hoping to pass the headache on to the buyer. Don’t let it be you.

Wrong Area. Don’t spend your money trying to reverse a trend. If the neighborhood is in decline, the property carries that stigma. Tenants will be moving on, and so should you.

Months on the Market. Good properties go fast. Bad properties linger in the listings for month after month. With detective work, you can figure out why it’s a dud. And that’s a viable learning experience. But your time will be better spent going after good deals.

Housing Slump Offers Opportunity In Apartment-Building Market

Published: Monday, 18 Oct 2010 | 9:56 AM ET

By: Sara Clemence, |Special to CNBC.com

The property in Fort Lauderdale, Fla. was originally valued at $285,000. Clint Gordon, a private investor in multifamily properties, offered the bank $50,000 cash—and within 10 days had closed the deal. A few days after that, he began renting it for $15,000 a year.

Barb Getty at one of her investment properties. "Anybody that’s getting into this business now, you get a whole lot of return if you’re paying cash for properties," he says. "You're just buying them so cheap."

Prices are “incredible” in Indianapolis as well, says Barb Getty, who owns 27 apartment properties in the downtown area. "You can start small like I did—20 percent of 40 thousand bucks isn’t a lot of money.”
Just as there have been massive price drops forsingle-family homesover the past three years, there have been big declines for apartment buildings. That suggests that it’s a good time for investors who want to be landlords to start buying.

But as with all investments, the story isn’t quite so simple.

Where’s the Flood?

Investors who thought that a tsunami of dirt-cheap multifamily properties would wash over the U.S. market in the past two years have been largely disappointed.

The distress was limited to certain places and property types, says Hessam Nadji, managing director at real estate investment services firm Marcus & Millichap.

"The pain was concentrated where we had gross overbuilding in overall housing: Florida, Phoenix, Las Vegas, Southern California, and to some degree smaller markets like Tucson, Charlotte and Atlanta," says Badji.

Marc Solomon, whose Solomon Organization owns 10,000 garden apartments in New York, New Jersey, Connecticut and Pennsylvania, says that it is difficult to find opportunities that make good business sense in his markets, which still offer slow, steady returns. "There’s a lot of dollars out there chasing these deals," he says.

While there were big price cuts in North Carolina's research triangle, competition is driving down yields, says Jim Scofield, senior investment advisor at multifamily real estate broker Apartment REP.

Last October, an investment firm “got a steal” on a community in Raleigh called Autumn River, with a capitalization rate of about 7.75 percent. The most recent transaction in the area involved a community called Southern Oaks, which had a 5-percent cap rate. (The cap rate is the full-year income from a property divided by the sale price).

"This is not just a phenomenon in the triangle, but in all the major markets—and especially all the apartment markets," Scofield says. "Manhattan, Washington D.C., Los Angeles, Denver, Chicago, Boston."

Risk and Return

There is less competition in markets where the supply is more fluid, but the risks are also higher.
"We landlords are happy," says Getty, adding the only thing preventing her from buying more properties is the ability to manage them on her own. Still, she hasn't been able to increase rents as much as she normally would.

Gordon says that his vacancies used to average three to five days. “Now I can have a vacancy of up to 60 days,” he says.

Despite all of the qualifiers, there is opportunity to be had in rental apartments because the timing is good, Nadji says. Average cap rates are still around 6.5 percent.

“I don’t think you’re going to get fire-sale prices,” he says. “But you can get that kind of return ahead of the job growth and ahead of the economic recovery.”

Rental occupancy rates contracted dramatically during the recession, as people doubled up to save money and young adults boomeranged back home. Vacancies nationwide hit a high of 8 percent in the last quarter of 2009, according to real estate research company Reis.

But industry insiders argue that rentals will bounce back quickly and dramatically as well. Indeed, in the third quarter of this year, vacancies dropped to 7.2 percent, according to Reis.

"Apartment rents are short term they adjust to market conditions very quickly," Hessam says. "We’ve seen a record demand for rental apartments so far this year—the strongest in over 10 years.”

Owning vs. Owning

Apartment buildings can also be attractive because investing in residential real estate seems similar to owning a home. But rental properties are different—starting from the purchase decision.

Homebuyers tend to look for a place they love that fits their needs and budget. But you have to see investment properties through the eyes of your tenant, Getty emphasizes. If your tenants won’t have cars, is it near public transportation?

Randall Gorman, president of La Jolla Capital Group in California, says prospective investors need to take the emotion out of their purchases.

"I don’t care if you’re buying a condo, a duplex or a ten-unit building," Gorman says. "Just because you’ve always loved that cottage-style apartment building that you drove by taking your kids to school, doesn’t mean the cash flow fundamentals work at a given price."

If considering a property, Gorman advises making sure you can run a cash flow model. Go beyond the cap rates the owner discloses, and figure out property rents by doing research online and in the neighborhood.
Calculate your annual revenue, and thoroughly survey costs like maintenance, taxes, utilities and incentives. (Property managers typically charge about 10 percent of a month’s rent.)

Add in a couple of months of vacancies—and don’t disregard the higher interest rates for commercial properties. According to PricewaterhouseCoopers, the national average interest rate for apartments in the third quarter was 5.68 percent. For the first week of October, Fannie Mae reported that the average 30-year fixed rate for a primary home was 4.27 percent.

If your final net income is $16,000 annually, aiming for a 10-percent cap rate puts the purchase price at $160,000.

"Don’t buy on what might happen, but on what is happening,"Scofield says. "Only buy a property if it is cash flowing to meet your investment return requirement on day one."

Even once you buy, it’s not a smart idea to treat your investment like a home.

"Investors make a huge mistake when they spend a lot of money on bells and whistles in their rental property," Getty says. "For instance, crown molding. A rental needs to compare well to others in the neighborhood, but don’t make it a palace—you won’t get that money back." 

Are Small Apartment Buildings A Smart Investment?

Fri, Apr 01 2011 00:00:00 E

By Kathleen Doler, For Investor's Business Daily

Posted 03/31/2011 03:57 PM ET

Recovering rents, rising occupancy rates and low sales prices are enticing investors to become landlords. The sweet spot for smaller investors is multiunit buildings with up to four units, according to market followers.
This size of apartment property can qualify for conventional financing backed by Fannie Mae (FNMA) and Freddie Mac (FMCC) with 20% to 25% down. When a landlord lives in one of the units, financing insured by the Federal Housing Administration may be available with as little as 3.5% down.

"I'm seeing rents go up in the markets where employment is strong: New York City, Seattle, Washington, D.C.," said Lesley Deutch, vice president of John Burns Real Estate Consulting, in Lake Worth, Fla. "All markets will be on the positive side this year."

How much rent growth just depends on where you are, Deutch says.
"Financing is starting to free up for more creditworthy investors," said Peggy Abkemeier-Alford, president of Rent.com in Santa Monica, Calif. "So small investors are scooping up multiunits."
In 2003, homeownership was 69% says Abkemeier-Alford. Now it's 66.5%, and "every 1% decline in homeownership equals 1 million new rental households."
Competition Big And Small
One caveat for investors is that smaller rental properties must compete with the many vacant homes now being rented out.
Slammed by a credit crisis and the recession, commercial real estate isn't out of the woods yet. But the apartment sector, which is part of it, is flashing encouraging signs for both big and small investors. In February sales of apartment portfolios priced $2.5 million and up rose 50% from a year ago to more than $2 billion, according to Real Capital Analytics. But it's still just a fraction of the activity seen a few years ago, and distressed properties accounted for 41% of February's sales.

Abkemeier-Alford predicts rents in top markets will rise 5% to 6% this year, and in bottom markets she expects 2% growth.

The national rental vacancy rate climbed to more than 10% on average over the past couple of years. But "in the most recovered markets in 2011 it will be around 5%, a big decrease," Abkemeier-Alford said.
Real Capital's analysis of large apartment deals found investor demand outstripping offerings around Washington, D.C.; Boston; Southern California's Orange County; San Francisco; Raleigh, N.C., and a number of Florida markets.

"In our area, sales of multiunit properties are very brisk," said Al Ricci, a broker at Ricci Realty in the Southern California city of Orange.

Where The Renters Are

Ricci works in an area called Old Town, near Chapman University. He says some parents are now buying multiunit properties to house their students plus other tenants. Rising rents, low vacancy rates, high on-campus student housing costs and low sales prices are bringing parents into the market as investors, according to Ricci.

He says triplexes that sold for $750,000 and up in 2007 are now priced at $600,000. But in his area, due to demand, "rents haven't changed." Ricci is the listing agent on three multiunit properties and expects to move all of them in 60 to 90 days.

Rental properties are an option for hands-on investors. Here, town houses line a Beaverton, Ore., street in 2009. AP View Enlarged Image

In Seattle, new hiring by Amazon.com (AMZN) should reduce rental vacancies and potentially drive rent increases, says Glenn Roberts, managing broker of Lake and Company Real Estate. "Amazon has leased 1.7 million square feet right next to downtown — they're really expanding," Roberts said. "And a lot of their employees won't be homebuyers yet, so they'll need to rent."
Roberts believes multiunit properties near downtown are an investment opportunity. "In the last 30 days, 13 multiunits have sold and closed, but there are 50 pending right now," he said.
The availability of low-down FHA loans for multiunits is often overlooked.

"People have been a little out of touch with FHA financing," said Rebekah Radice, a mortgage planner with Benchmark Mortgage in Colorado Springs, Colo. And some folks think FHA only offers small loans. But it raised the lending limits in high-cost areas, and then extended those raised high-cost loan limits to Sept. 30, 2011, Radice says.

FHA loans require mortgage insurance, paid in monthly premiums. After an April hike, the cost will range from an annual 0.25% to 1.15% of the loan amount atop a 1% upfront fee.

Michael Simpson, a multiplex property investor in Sacramento, Calif., advises new landlords to screen tenants, keep an eye on their properties and keep detailed books.

Simpson also says that potential landlords should research how their city or town treats multiunit properties. In Sacramento, any property with more than three units requires more extensive permits for remodels than a single-family building, he notes.