Cap Rates

When dealing with commercial properties one of the more useful tools to determine the investment potential a deal are the capitalisation rate or cap rate for short. The definition of cap rate is the annual return from operations that an investor would expect to receive for a certain asset in a specific market at the current time, if the asset were to be purchased for all cash.

The easiest way to understand cap rate is the expected percentage of return an investment will generate based on the net operating income (NOI) of the asset.

Variables that come into play are market conditions, the location of area, the class of property. To determine the cap rate a combination of industry research, local market evaluation and deal marketing, and transactions are taken into consideration. Because I’m looking to invest in multi-family deals which are homes or apartments with multiple families living under one roof, we will look at how to determine the best evaluation on a deal. The next step then the class of property you want to invest in:

Class ABuilding in prime location or new constructionEquity Appreciation, stable expanses
Class BBuildings in need of light renovation and are well maintainedEquity appreciation or cash flow, Stable Expanses
Class COlder building in need of infrastructure and function improvementsCashflow, fluctuating expanses, deferred maintenance
Class DProperties in disrepair, outdated and are managed badlyValue Add/ Distressed

Different classes provide different levels of risk which directly related to the amount ROI. Because class-A properties are targeted at an income level above average, the risks would be low, so we can assume that you will attract good tenants but the return on average in lower then with risker classes. Properties in Class-D would provide the most return on investment but we can assume there will a lot of maintenance, a low

How to Use Cap Rate

The rule of thumb is that you buy at a higher cap rate and sell at a lower rate. Here’s why?

Let’s take a complex in Rosettenville, south of Johannesburg, that I agent came to us with. The complex is 10 unit apartment complex listed for R1 Million. Our research indicates it is a Class-D property. We qualify this assumption by investing and determining the building has not been properly maintained in years, infrastructure such as electricity and plumbing needs to be updated. To make matters worse the current tenants have not been screened properly.

Based on my talks with Estate Agents and feedback from a coach the cap rate in that area is about 10%. Lets look at example where we would like to determine the net income of the deal and assume we put down 25% as a capital investment and just for simplicity sake I will not include any loans:

R1 mil x 10% = R100,000

Now lets assume that we want to buy a building that generates an NOI of R240K:

R200K / 0.1 = R2 mil

So in order to achieve R200K NOI annually we would to find a property in that area worth R2 mil. But remember, we buying a Class-D property which means there’s a possibility to increase the NOI by adding value to the property. We assess the value-add and that we can improve the NOI by R50K just by increasing rents, placing prepaid meters and reducing expenses through our trusted management team.

R250K / 0.1 = R2,5mil

So you bought the property for R2 mil and by increasing the NOI by R50K, either through the short term or long term, you have increased the value to R2,5mil. That’s 500K in your pocket that you can use for the next deal.

The market dictates the cap rate, and the cap rate is based on the NOI. In this case, the cap rate at purchase and sale remained the same, but the NOI was raised by 10 percent. There is also an opportunity to refinance the property. This would result in changing the value by using a lower cap rate.

What I Got Wrong

On the 1st 5 unit apartment I made an offer on I did not factor in all the expenses or dig deep enough into the numbers to uncover the true value. This was because I didn’t get the full picture of the performance of a property. That is to say the agent or seller either didn’t include all of the expenses, based their projected rents off an estimate, or do a combination of both.

The first red flag is when the term pro forma (Theoretical) is used as a basis of the stated cap rate. This means that the rents and expenses are in most cases absolute best-case scenario or rather projection-based. A more accurate way to determine the actual performance is by getting a trailing 12 months profit and loss statement. Many agents will only send you a spreadsheet with actual numbers for income, taxes, insurance, and maybe utilities. The rest is up to you to determine.

You will also base purchase decisions on your own pro forma, which is what you will create, in terms of value add, to determine the value as you see it.

Say you are looking at a 10-unit property that is being sold for R10 million at a 4 percent cap rate. The net income should be R400K a year (R10,000,000 x 0.04 = R400,000). The rent role docs state that the pro forma rents are R5K a month per unit.

That means R50K a month and R600K a year. So far, so good. The pro forma expenses total R200K, which gets us to the R400K NOI.

Now, let’s say this property actually is generating an average of R40K a month in rent, and the expenses are 45 percent of the income. This brings us to R1,800 per unit x 10 units = R18K per month and R216K per year.

At the same cap rate, the property is actually worth R8,64 MIL (R216,000 / .04 = R8,640,000). This mean the property is overvalued by R1,360,000!

What to Expect

Here is the minimum list of expenses you should expect to see in an offering—and also dive in deep to validate in your analysis:

  • Property taxes (normally accurate, because they are public record)
  • Insurance
  • Utilities paid by owner
  • Maintenance and repairs (5-10% of value per year, depending on class)
  • Landscaping and pool maintenance
  • Municipal licensing
  • Property management (8-10% of gross rents)
  • Vacancy (5,5 – 10%)
  • Variable expenses

If you get these right, then you will be much closer to actual costs. Still, this is heavily dependent on the complete and accurate records of the owner/manager of the property.

Why Use Cap Rate

There’s a lot to say about cap rate that I’m learning about. This could definitely be a much longer post. So, to conclude why we use cap rates:

  • It accounts for both revenue and expenses.
  • It reflects the supply and demand for a particular asset type in a certain location at a specific time.
  • It reflects the asset grade.
  • It is a standard metric that is widely used by most operators, investors, and brokers.

If you only get a one-page spreadsheet, or just an offering document from the broker, then you will most likely not be able to get a good picture of the financial performance of the property. This is where a little more help from experienced investors will tap into resources with hands-on experience in the immediate market and comparable asset classes to help develop a framework of realistic numbers.

Learning how a cap rate is calculated will help you go a long way in evaluating investment-grade properties. It is even more important to be thorough in your analysis and realize that it’s just one tool to master.