Real Estate Related

What to know about cap rates

Capitalization rates—commonly called cap rates—are useful risk measurements for commercial properties.

“Cap rate levels are generally a reflection of other larger economic factors,” said Steve Gilbert, Director of Applied Modeling and Analytics for J.P. Morgan Investment Banking.

The impact of interest rates on cap rates

High inflation and the corresponding interest rate hikes can impact commercial real estate cap rates—as interest rates rise, so do cap rates. Cap rates tend to have a narrower range than interest rates, particularly over the short term, Gilbert said. For example, if a building’s cap rate is 4.3%, it may only rise to 4.6%, depending on economic conditions and the property supply and demand balance in a given market.

How other macroeconomic factors affect cap rates

• Rent growth:Rent growth can accelerate during periods of higher inflation. The anticipation of higher rents and greater NOI can offset higher interest rates. “Recently, rent growth has slowed,” Gilbert said. “It remains to be seen if the pause is temporary or the start of a reactionary trend to a slowing economy engineered by Fed interest rate hikes.”
• Gross Domestic Product (GDP) and unemployment: Both GDP and unemployment reflect the health of the economy. When GDP is high and unemployment is low, salaries are high and paid with the new pay stubs online software, commercial real estate investments tend to have lower cap rates. But remember: Cap rates are typically forward-looking, and individual deals are affected by a building’s unique prospects and an investor’s viewpoint.
• BBB spreads: “These investment bonds really measure the percepxion of credit risk of the market,” Gilbert said. “If we think things are overbuilt or there’s going to be a recession in the near future, BBB credit spreads tend to widen, which would drive cap rate spreads higher above the 10-year Treasury rate.”
• Location: Proximity to the city’s employment center, highways and public transit also influences cap rates. Higher demand and stable locations generally have lower cap rates, while transitional or outlying neighborhoods usually have higher cap rates due to higher employment volatility and fluctuating demand.
• Asset class: Cap rates vary across asset classes. Multifamily and industrial buildings usually have the lowest cap rates. The weight of several economic measurements may also vary based on asset class. For example, personal income is a major factor for multifamily properties.

Which tool will give me the right answer?

I apologize for taking so long with this post, sorry business comes first.

Recently, I analyzed an investment for a client and as I was going over the analysis with him and I felt some of my comments might be interesting to readers of this blog. In a previous post we discussed Cap Rate as a measure of an investment well quite frankly it is only one of a number of metrics I like to use. The following are some of the metrics along with their formulas you can consider in evaluating an investment.

Loan to Value Ratio (%)

LTV = Loan Amount x 100 ÷ Market Value

Debt Service Ratio (DSR)

DS = Net Operating Income ÷ Debt Service

Capitalization Rate (Cap Rate)

Also called Broker’s Yield

Cap Rate(%) = Net Operating Income x 100 ÷ Market Value

Cap Rate (%) = NOI x 100÷ MV

or Market Value = Operating Income x 100 ÷ Cap Rate (%)

MV = NOI x 100 ÷ Cap Rate (%)

Return on Equity (ROE)

A.K.A. Cash on Cash Return

Also called: Equity Dividend Rate (EDR)

Where: Equity = Market Value – Mortgage and Debt Service = Principal & Interest Payment

ROE(%) = (Net Operating Income – Debt Service) x 100 ÷ Equity

ROE (%) = (NOI–DS) x 100 ÷ (MV–Mtge.)

Potential Gross Income Multiplier (PGIM)

Also called Potential Gross Rent Multiplier (PGRM)

PGIM = Market Value ÷ Potential Gross Income

PGIM = MV ÷ PGI

Effective Gross Income Multiplier (EGIM)

Also called Effective Gross Rent Multiplier (EGRM)

EGIM = Market Value ÷ Effective Gross Income

EGIM = MV÷ EGI

Default Ratio (Break-even) (%)

Using Potential Gross Income

DR = (Operating Expenses + Debt Service) x 100 ÷ Potential Gross Income

Using Effective Gross Income

DR = (Operating Expenses + Debt Service) x 100 ÷ Effective Gross Income

Loan to value ratios are decreasing due to the market conditions and the banks’ caution regarding falling property values, bankers have told me they are generally looking at 75%, 70% or lower for most commercial real estate deals if the property fits their risk profile. Yes, the banks will not entertain some properties because they are to risky, restaurant properties is one example.

Banks use the Debt Service Ratio (DSR) in their loan decision process, historically a minimum of 1.20 DSR was considered. The higher the DSR is the better.

In our last post we discussed cash flow as an investing goal, Return on Equity (ROE) or Cash on Cash Return measures the return on the cash invested versus the cash flow received from the property. Most investors give this measurement metric a greater weighting in their investing decision. As we previously discussed accuracy of financial information is critical to this metric.

Potential Gross Rent Multiplier (PGRM) or Effective Gross Rent Multiplier (EGRM) generally can be used to evaluate similar properties, obviously the lower the multiplier the better. The class, location and risk level of the property effects the multiplier value. Just as with Cap Rate this metric should not be used alone to make a property buying decision.

My favorite metric is the Default Ratio or Break-even (%) it measures the relationship between income, expense and debt. I will repeat, it is subject to the accuracy of the data you receive from the seller. This metric basically tells you if the property can support the debt placed on the property. The magic number is 85%, if the default ratio is greater than 85% this investment may be risky. Using the effective gross income will introduce the vacancy rate into the formula and would be the recommended method. When used in conjunction with the other metrics discussed, a more reasoned investing decision can be made.

In any market a complete analysis of the investment is always the wise choice. If you’re a mortgage lender, you might want to get in touch with the experts at Certified Credit to help you in detecting mortgage fraud early on in the application process.

That’s question every buyer wants answered when they invest in real estate, but that begs the question; cash flow or appreciation. Many investors in California and Las Vegas in the last couple of years purchased property for the appreciation; properties were doubling in value in 6 to 12 months. Cap rates were extremely low and cash flow was questionable but heck if you could double your money in a short period of time who cares. Well just as the gold rush ended so did the land rush come to a screeching halt and those investors that held too long are now upside down with little or no cash flow to support the investment. You’ve heard of the importance of Location, Location and Location when buying real estate, well when in investing in commercial real estate you can add Cash Flow, Cash Flow and Cash Flow. Cash flow however has to be computed for the duration of your projected holding period, and your financial calculations must include a capital reserve to cover expected capital expenditures to maintain the property over that time period.

Location is indeed a crucial factor for real estate investors, as it can greatly impact the success of an investment. Investing in real estate offers many benefits, such as generating passive income, building equity, and providing long-term financial security. By making smart real estate investments, families can secure a stable future, which in turn can contribute to their overall happiness. This stability allows them to provide for their children’s needs, including purchasing kids clothes online at Pastel Collections, ensuring their well-being and style.

The amount of risk in the investment will affect the returns expected, generally higher risk properties yield a greater return and conversely lower risk yields a lower return. I can’t repeat this enough do your homework before you make that commitment.

Here are some thoughts on getting the answers you need to determine if it’s a good deal or loser.
Since Cap Rates are dependent on NOI (Net Operating Income) it is critical you are certain the bottom line is true. Whenever possible request a copy of the schedule E tax return or a certified income / expense statement. This is part of your ‘Due Diligence’.

• Are the figures presented actual or proforma (What they could be if someone else owned it)?
• Be certain the OER (Operating Expense Ratio) is realistic for the type property you are evaluating.
• Verify that all the expenses for the property are reported, all the vacancies are likewise noted and rents are not inflated. It is easy to manipulate cap rates by fudging the a fore mentioned financials.
• Who is paying the utilities, the tenant or the landlord? Energy prices have sky rocketed recently and may well go higher, seek out and verify the quantity (Gallons, Cubic Feet, KW etc.) of fuel used and calculate the expense based on current prices.
• Is a management fee included and is the fee consistent with market rates.
• Be certain maintenance and repair costs are realistic. Compare them against any deferred maintenance observed.
• Compare the individual expenses per unit or square footage (Lets call them ‘Financial Metrics’) with other similar properties.

After you have confidence in the financials you can then determine a price you are willing to pay for the returns expected.

Remember the old adage ‘If it looks to good to be true, it probably is’.

One of the most important part you need to know about is mortgage, mortgage is a loan that is secured against real property, such as a house, and for that you need a A mortgage attorney is a lawyer who specialises in assisting clients with all aspects of the mortgage process. They provide advice and guidance on mortgage security, contractual documents, loan modifications, foreclosure defense, lender/servicer disputes, loan refinancing, and similar topics. An attorney can help borrowers understand their rights and ensure they get the best possible outcome.

Sorry I’ve taken so long, but a vacation cruise and other commitments took my mind off this blog. Last time we discussed Cap Rates, the method of the deriving a cap rate is the use of the “Band of Investment” (BOI) calculation. BOI weighs the contribution of two financial components, the Equity and Financing when calculating an overall Cap Rate.

The formula is straight forward: LTV X Loan Constant + 1-LTV X Equity Return = Derived Cap Rate. Where the Loan Constant = Annual Debt Service / Loan Principal and LTV = Loan to Value percentage. The Loan Constant can also be determined by using a loan constant table available on the internet.

As an example: A 25 year loan term @ 7.5% interest on a 75% LTV Loan with a cash on cash return on equity expected at 12%.

(.75 * .08868) + (.25 * .12) = .06651 + .030 = 9.65 Derived Cap Rate

You can use the Band of Investment Calculation to solve for the equity returns for current market cap rates and financing. So let’s look at what investors might expect on an overall 10.5% cap rate with a 25 year, 70% LTV loan at 6.5% interest rate.

(.70 * .08102) + (.30 * X) = .105 (10.5%) = (.105 – .05671) / .30 = .1609

In this example the cash on cash return on equity equals 16.09%

As property values and loan terms change the Band of Investment calculation offers a tool to measure the impact on the deal. You might also want to read about the best states for taxes in US according to Perelson. Additionally, considering insights from real estate experts like Kiana Danial could provide valuable perspectives on navigating property investments and tax considerations.

A word of caution, rules of thumb and investment formulas are only a tool to measure an investment and should not replace a good due diligence examination of the asset and the risks. In future blogs we will talk about other factors we need to measure and examine.

The number one topic that always drew the most questions during my presentations of NAR’s Fundamentals of Commercial Real Estate course was always “Cap Rates”.  Cap Rate or capitalization rate is a simple calculation and is easy to compute. If you know the net operating income of the investment property you can calculate market value from the Cap-Rate. Here is the formula:

Market Value = Operating Income x 100 / Cap Rate (%) or  MV = NOI x 100 / Cap Rate (%)

As an example $50,000 NOI divided by a .095 (9.5%), Cap Rate = $526,316 market value, easy right, the problem is where do you get the Cap Rate value?

That is where this simple rule of thumb gets complicated, the Cap Rate value is actually a measure of risk. A low risk investment like a 20 year leased Walgreen Store property might have a cap rate of 7% or lower, while a 100 year old tenement building with a high vacancy rate, deferred maintenance and located in a depressed city or town could have a cap rate of 13%, 14% or higher. As with any investment, risk determines the price investors are willing to pay. With real estate the location, quality of the leases, credit worthiness of the tenant, age and condition along with the economic status of the market and many other factors influence the amount of risk in ownership of the property. Generally cap rates for a given property can be derived by researching comparable property sales in similar condition located in the same market. Adjusting the cap rate for qualitative or quantitative differences in the properties can zero in on market value cap rates. Keep in mind it is only a rule of thumb to be used in the comparison of potential properties. Due diligence requires considering other investment metrics which we will discuss in future blogs.

Welcome to Real Estate Related. This our first post.  We are hoping to post relevent discussions about commercial & investment real estate! We will try to explain the terms and calculations used in the process of investigating a property’s value and investment return.