Understanding CAP Rates
The CAP rate; or capitalization rate, is the relationship of the net operating income (NOI) of the property divided by the sales price or appraised value. So a property with $200K of NOI that sold for $2 Mill, sold at a 10 CAP – (200,000 divided by 2 mill). Now, while CAP rates may vary some by city and property type, a general idea of CAP rates will help you screen out deals that don’t make sense. Knowing the CAP rates can help you estimate the real value of the property you are looking at financing and this can help you determine whether it is even a viable deal.
Most listing flyers and many borrowers think their property is worth a 7 CAP. No lender in America would give someone a 7 CAP on a property in 2013. In 2007, average pricing was a 7 CAP and in some places like California, you were even seeing 5.5% CAP which is crazy. A property barely cash flows at that CAP rate. Today, cap rates seem to be stabilizing around the country and they seem to be trying to get closer to the old days of norm. Let me show you what I mean by an example….
Say a property has a $200K NOI. On a 7 CAP that property is worth $2,857,000. That was the price in 2007 nationally. On a 10 CAP, that same property with the same NOI of $200K is worth $2 million even. Today, prices are coming in closer to the 10 CAP number. When I get a loan and screen it, I calculate my NOI and then divide by .1 (a 10 CAP) to see if we are even in the same ballpark. Usually, the deal is either close or way off. IF way off, you just saved yourself a ton of time working on a deal that will never appraise. If close, you can have a better look. There are lenders willing to underwrite at an 8.5 CAP so if I was close at 10.
And different areas and property types support a lower CAP rate. But the 10 CAP is a great place to quick screen and see if you are in the ballpark. Knowing this will save you from doing a lot of work and then getting a low appraisal and having the deal tanked. It saves you time and money. Please note, this is just an example and the numbers are for demo purposes only.