Hey Sherman Ragland, the Realinvestor and today we’re gonna talk about cap rates. Cap rates and we’re gonna talk about what exactly is a cap rate? How do you calculate a cap rate? When do you use it? Most importantly, when you should never, ever, ever, ever, ever use a cap rate. Coming in a minute. Hey, Sherman Ragland, Realinvestors. So notice here, we’ve got three apartment buildings One, two, three apartments right next to each other and would you believe it, these three apartment buildings are completely different in terms of their valuation, completely different in terms of what they have sold for. Why is that, how can you have three buildings all in a row kind of sorta looking like each other and yet, they are three separate different valuations? So today we’re talking about cap rates, or capitalization rate or in the industry, the rate, and what we’re talking about is how do you value specifically income producing property, like this apartment building right here. Lot of folks are out there on the internets, chattering and talking about cap rates. And quite frankly, I see a couple of people out there really talking about it and answering people’s questions on it completely wrong. So today I’m gonna dispel the myth and we’re gonna talk about what is a cap rate, how do you calculate a cap rate? When do you use it and when should you never, ever, ever, ever, ever use a cap rate? So, first of all, what exactly is a cap rate? Well, a cap rate is a very short and sort of dirty quick hand notation of what a property is worth based on two factors. Number one, what is the sales price of the property or what is the purchase price of the property or what did it sell for, or what is it potentially worth? And I’ll explain all that in a second, versus how much income does it produce. Now in the world of real estate, we talk about a specific kind of income and that income is called NOI or net operating income. And think about it like this, real estate really sort of, like, especially something like this, should be a self-contained business, meaning you should be able to hire somebody. You should be able to manage it and you should be able to go on and live your life and have these checks deposited in your bank account. Sort of passive income, true passive income where you’re not out here collecting rents. You’re not out here mowing the grass. You’re not out here doing anything. It’s all being handled by the property manager. And because of that, people look at these as self-contained investments sort of like buying a business or buying a franchise or buying, I don’t know, vending machines or buying a hotel. They’re looking to make an investment based on the income that is coming at you and so when we do a valuation using a cap rate, we’re making our valuation of the property based on what’s called the income approach or the capitalization rate. So let’s take a real quick and dirty example because, again, cap rates are meant to be used in sort of a quick and dirty fashion, like a back of the envelope or back of the napkin. And let’s say that you have a property that’s producing $100,000 of net operating income. That’s $100,000 of income directly related to the operation. So I take the actual income coming from the property, I subtract the actual expenses related to the property. I don’t include income taxes and I don’t include the mortgage payment on the mortgage. I will, of course, include property taxes as the property taxes are unique to the property. So I take all of the income, potential income, subtract out a vacancy allowance or bad debt allowance. I subtract out the actual operating expenses and what’s left over is the money that’s left over to both service the debt to the lender and/or pay the equity holders. And so that income that’s left over is called the net operating income. So if I were to buy a property that has, let’s say in this example, $100,000 in net operating income and I were to pay $1 million, I basically would take the 100,000 divided by the million and I would come up with 0.10 or 10%. And so in this example, the cap rate for this building is 10%. So one of the ways that we can use a cap rate is like I said, back of a napkin, down and dirty, sort of calculate real quick, what do I think a property’s worth? So let’s say that my buddy Fred calls me up, he says, “Hey, Sherman, you remember Petey?” I’m like, “Petey, Petey from high school?” He says, “Yeah, Petey owns that laundromat.” And I said, “Yeah”. He says, “He wants to sell the laundromat.” And I said, “Well, what does Petey want for the laundromat?” He says, “Petey wants $1 million.” And I said, “Okay, what’s the operating income from that laundromat?” In buying the real estate, the coin-op machines, the whole nine yards, the whole kit and caboodle. What’s the income coming off of that laundromat? He says, “Petey’s making $100,000.” I said, “Okay, well, what does he want?” He said, “He wants $1 million.” Okay, that would be a 10% cap. Now, if I’m interested in earning 10% of my money in a true passive fashion, I might very well go for that investment. Now I’m not gonna buy it just based on the cap rate. I’m gonna do my due diligence, I’m gonna do my appraisals. I’m gonna have my engineer go in there and just make sure that everything’s correct. I’m gonna have my attorney look at all the documents and make sure that all the permits and fees that are necessary are in place and any additional leases. So I’m gonna do all of that due diligence, but I’m gonna first make my offer based on the cap rate. Now, what if my buddy says, “Hey, Petey wants to sell that laundromat and he wants $1 million.” And I said, “What’s the income?” And my buddy Freddy says, “It’s only $50,000.” Well, that would be a cap rate, again, taking the math. 50,000 divided by a million. That would be a cap rate of 5%. And I gotta say to myself, is it worth it to make an investment for only a 5% rate of return? And so everything is kind of relative. And so for some group of investors, a 5% rate of return’s okay, but for me, I probably wouldn’t go for something like that. Well, by being able to use a down and dirty, back of the envelope analysis, what’s the NOI divided by the asking price to determine the cap rate for that deal, I can very quickly decide is it worth pursuing or not pursuing. And there’s no sense spending time, energy, money, resources, to pursue a deal if the rate of return just isn’t there. So that’s the first way that we use cap rate. We just sort of like, tell me what the numbers are and I can very quickly at the back of a napkin, if I know the NOI and I divide it by the asking price, I can determine the cap rate, Or correspondingly if somebody says, “Hey, so and so is selling a property at a 10 cap.” And I say, “Okay, well, what’s the income?” And he says, “It’s a $100,000.” Then I know he’s asking $1 million. If he says, “It’s $1 million income.” Okay, I know he’s asking $10 million just simply by knowing what the cap rate is. So that’s how we first and foremost use cap rates, number one. Number two, when it comes time to get a loan, we’re typically gonna go to some lending source, a banker, a community based bank, or savings alone. Excuse me, I said savings alone, didn’t meant to say that. Or credit union, credit unions are really getting big into the commercial real estate space, commercial real estate lending space. And the lender is gonna calculate certain things and one of the most basic things that the lender always calculates is loan to value. So how does the bank calculate a loan to value? Well, they use a cap rate, meaning if I was to say I wanted to buy this apartment building right here and my lender said, “Okay, we’ll loan you 80% loan to value”, and it turns out that the apartment is worth, again, in this conversation, a million bucks. That means that the lender would loan me 800,000. Well, how do they come up with the value? Are they gonna send an MAI appraiser out here and spend 10, 20, $30,000 for an MAI appraisal? No, an apartment like this, an MAI appraisal’s probably gonna be like 6, $7,000, but still, are they gonna spend 6 or $7,000 to have the building fully appraised? No, the banker’s going to use a cap rate to determine value. They will look at the income from this building and use a cap rate that they believe is an appropriate cap rate and they’ll come up with value. Now, where does the lender get their cap rate? Well, they’re typically gonna call somebody like me, somebody who is a professional in the business, who’s got a CCIM designation who understands commercial real estate and the conversations are gonna go like this. “Hey Sherman, we’re looking at funding some properties up in the Reservoir Hill section of Baltimore. What are you seeing for cap rates?” And what I will do is determine what the income is for a variety of properties in and around the neighborhood. I’ll see what the sales prices have been and I will calculate a cap rate for them and share that information for them. Or if it’s a very active lender who’s very active in this marketplace, they may very well have enough deal flow of their own and have seen enough deals that they know what the cap rates are in and around certain parts of town so the lender will calculate a cap rate. And that’s the second way the cap rates are used is, again, very quickly determine value for part of an underwriting exercise. That’s what bankers do, they underwrite the deal. And then the third way the cap rates are used is oftentimes investors will buy a property and then at the end of the first year, they’re gonna say, okay, we paid X amount of money for the property, what was our net operating income for the property? What did we get as a rate of return? So just as a snapshot in time, they’ll calculate what the cap rate is. So that’s what cap rates are and that’s, for the most part, how cap rates are used. Bankers use cap rates to determine what value is so they can make their loan decisions in the underwriting. Investors use cap rates to determine what should a property sell for or what would I be willing to pay for it based on various cap rates as sort of a preliminary back of the napkin or initial analysis. And of course, real estate agents and brokers like me use cap rates all the time to say, “Hey, if you buy this property at this number, you’re gonna get an X-rate of return.” Or, “The property’s selling at a X cap”. You know, six cap, a five cap, a 10 cap, whatever. And, oh, by the way, anytime you hear somebody say 10 cap, that is almost always simply because the math is simple. Almost nothing ever sells on a 10 cap outside of, you know, an example in a class or example on a YouTube video. But the bottom line is this, cap rates are a great tool for the right kinds of property. What’s the right kind of property? Income producing property, hotels, apartment buildings, commercial office space. Cap rate is more than, more than, more than appropriate. In fact, that is the number one way that valuations are going to be done, but cap rates are never appropriate for another kind of property. And that’s what I’ll talk about real quick right now. So it’s completely appropriate to use a cap rate for commercial properties like this. But, so when should you never, ever, really ever use a cap rate? Well, single family houses. Single family houses are almost never evaluated using cap rates and this is one thing that’s really concerning me right now ’cause I see a lot of conversation in a lot of different real estate groups talking about, “Hey, I just bought a single family house. What should my cap rate”, you don’t use cap rates for single family houses. And I don’t care whether it’s a single family house being used as a quote, unquote “traditional rental property” for people using housing vouchers or market rate housing or if you’ve converted the house into an Airbnb or a assisted living facility. Single family houses are evaluated using a completely different technique and cap rate is only going to probably screw you up. Let me tell you what I mean by that. Single family houses are evaluated based on what’s called comps or comparables. And I did a video many years ago, it’s still very relevant today, where I talked about the fact that 80%, 80, 8 0, 80% of the value of any single family house comes from the neighborhood where it’s located. So as you can see, this house right here kind of looks like the house next door, kind of, sort of, which looks like the house two doors over, which looks like the house three doors over. So 80% of the value of this house is coming from the neighborhood regardless of how the house is being used. It doesn’t matter if it’s being used as a three or four or five bedroom assisted living facility. It doesn’t matter if it’s being rented out for several hundred dollars a day as an Airbnb. The value of this house comes from the comps or comparables. So here’s the scoop, cap rate totally perfect for income producing properties, apartments, commercial properties, commercial office buildings, neighborhood shopping centers, et cetera, et cetera. But when we’re talking about single family houses, single family, one to four is how the banks classify ’em, the value of this house is gonna come from its comparables. And so therefore, cap rate is only going to mess you up. Let me tell you what I mean by that. Let’s assume for a second that I come to the analysis and I say, hey, this house is worth $300,000. But if I turned it into an Airbnb or I turned it into a assisted living facility, I can generate two X, three X, four X, five X. In some cases, 10 X the revenue. Well, if you were to use a cap rate on a single family house like this that’s being used for assisted living, as a matter of fact, you could five or 10 times the revenue, which means you could five or 10 times the value. Well, this house that’s $300,000 because that house is 280 and that house is three and a quarter. And this house back over here is, you know, three and change like, and all the houses are roughly around 300,000. This house is not suddenly worth $3 million simply because it’s being used as an assisted living facility. And when you use cap rates in that way, you really kind of mess yourself up. So again, one more time, single family houses, we never use cap rates. I can’t think of any single good example where it would make sense to use a cap rate when talking about a single family house. On single family houses, we use comps. On commercial properties, we use cap rates and on institutional properties like a firehouse or a stadium where we’re looking to say, hey, what’s it worth? We typically use something called replacement costs. In fact, when you talk to most appraisers or CCIMs, they’ll tell you that there’s three ways to evaluate a property. Replacement costs, which is totally perfect for municipal properties where they are not gonna be rented out for anything. Comparables, which is the number one way that we do single family houses, and comparison value, or excuse me, comparison value is comps, comparison value for single family houses and, of course, cap rate or capitalization rate or income capitalization rate for commercial properties. So I hope this has helped clear some things up. More questions on this topic or any other topic, feel free to reach out to me at Ask A Realinvestor, askarealinvestor.com and please like, share, subscribe and let folks know that you are a big fan of Realinvestors and a big fan, also don’t forget our 21 day challenge. We’re gonna show you how to become a real estate investor, if you’re looking to get your first deal done, in as little as 21 days. So Sherman Ragland the Realinvestor. Thanks for tuning in. Look forward to seeing you next time, bye.