Defining Capitalization Rates

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Defining capitalization rates by looking at local listings won’t help you at all. Most cap rates are fantasies at best.

Transcript: Let’s talk about cap rates today and what that means as capitalization rate. Let’s define it. All that is, is a net operating income of a property, divided by what you’re going to pay for it. What makes up a net operating income, NOI? All that is, is gross scheduled income, GSI, which is the income you expect for the year, real rents not projected. You take away a vacancy rate that you know is pretty spot-on because you researched it or your professional did. By the way, when you take away vacancy and the vacancy rate, from a gross scheduled income for the year, what’s left is what’s called gross operating income, GOI. Most people don’t even know that exists. Most pros don’t know that exists unless they’ve really been educated and trained at our old school. What comes after that is all the operating expenses are then subtracted, and you end up with a smoke-cleared, net operating income. That doesn’t take into account any loan payments you might have, so don’t get sucked in by that. A loan payment is not an operating expense. It’s what we call debt service. A payment is debt service. You’re servicing that loan. Let’s take a property that is selling for $100,000. The income from that property is $17,000 for the year. You look at vacancy rates, and you look at all the operating income, and you say you know what, we’re going to have a $10,000 net operating income for the year. You say that will give us a 10 percent capitalization rate, because remember, you’re taking that net operating income, $10,000 in this case, you’re dividing it by the purchase price, $100,000, and you get 10 percent. If you don’t get a percentage, you divided the wrong numbers. I know because I’ve seen you do it. Here’s the thing. Arriving at a cap rate is easy. Arriving at an accurate cap rate isn’t so easy. Here is the problem. Sellers all over the country will put their rental properties for sale, sometimes by owner. Sometimes, they hire Larry from their local real estate brokerage that sold their house for them. They think that he knows about investment property because he once bought a duplex back in ’89. What they do is they put an operating statement that says yeah, we’ve got $17,000 of gross rents, and we know this because here’s the leases. Okay, so far so good. When it gets to vacancies, they say that this neighborhood is so good that there are almost no vacancies. You can’t accept that. Even if it’s true, you can’t accept that. My rule is, when I used to teach analysis to other pros, is that you just chose 5 percent when you know it’s 5 percent vacancy rate, or anything less including almost 0. Use 5 percent. Nobody’s ever upset when it’s less. Here’s the deal. You’ve taken away your vacancy rate. Now you’re going down all the line items of the various operating expenses that apply to this property. One of the big ones is real estate taxes. That’s easy to get right down to the dollar. You just research it. There it is. The guy shows you his tax bills. If you know that they’re going to be reassessed upon sale, you know the formulas they’re using. It’s usually very transparent at the City Hall. You take care of it. Then you have property insurance. How hard is that to find out about? You talk to the Farmer’s Insurance or whoever you do business with, and you get a bid, and you compare it to the other guy and you take the one you like. Then you have repairs. You have maintenance. You have property management if you’re going to use that. You look at all those things, and you add them all up. You combine them with a vacancy rate figure, okay? What if the vacancy rate is 10 percent? That just means that your $17,000 a year scheduled rent is going to inflict $1,700 lost due to vacancy. If it’s a 5 percent vacancy rate, it means you’re going to lose $850. None of this is rocket science, right? The key is you either want your professional or yourself to be putting their own boots down on the ground to find out what the rent should be versus what they are. Are they too low to the market? Are you projecting rents that you’ll never get? Where is your vacancy factor? Are you just doing an automatic 5 percent, or have things changed in the last 18 months they’ve really been 6? That’s going to come out in the wash whether you like it or not. Here is what you want to take away from this. Numbers are never more reliable than how accurately researched they are. That’s the thing about rents, and vacancy factors and operating expenses. There’s just no excuse not to be very close on most, and exact on some. You want to cap rate that when you say it out loud, people don’t laugh. That’s what’s going to happen when you see somebody who hired a house agent who says well, see at $17,000, the real estate taxes on this property are going to run you around $1,500, and you’re going to have give or take about $1,000 a year for insurance. That’s $2,500, and another $500 for repairs and maintenance where your net operating income is going to be $14,000. No it’s not. We both know, because we put our boots on the ground, it’s going to be $10,000. You’re going to get a $4,000 surprise if you believe somebody besides your own self and your own lying eyes, or the professional you hired and his lying eyes. Be correct on the numbers. Otherwise, the cap rate is nothing but a bad joke.

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