17 - Understanding money and CAP RATES
For many of us when starting out, we may have the unfortunate experience of coming across a commercial Real Estate agent or one of those "MBA" types we really want to call "MB Eh!" think you better than me people. This person may also be a Lender who wants to test you to see how qualified you really are to be in the real estate business.
What maybe unfortunate is these people throw bigs acronyms around and CAP rate is one of those. Fear not! For here is the summary that will make you the real estate GURU of the next fancypants party and impress your Mortgage or Bank lender person.
CAP RATE SUMMARIZED: Congrats on your purchase! What is your exit plan?
The day you buy is the day you made your money when you sell. This means from Day 1, you need to be in a position to either be making the cash flow or have the ability to make a considerable amount of cash flow over time. At the end of that time you hope to sell for more money. Sit down with your stakeholders or partners and make a plan, to buy, to manage, and then sell from day 1.
Understanding cash flow and rates of return
This is the simplified version. What one needs to know is:
1) What is the total projected or real income for the year?
2) What are the total expenses for the year?
TOTAL INCOME – TOTAL EXPENSES = NET OPERATING INCOME (NOI)
3) Now what is the value or sales price of the building TODAY?
CAP RATE = TOTAL VALUE TODAY /(divided by) NOI
4) With this number you can see how many years it takes to pay off. A rule of thumb is if it takes 6 years or less this is a good deal.
- Example: price of property is $200k
- Income on four units is $1000 a month X 4 = $4000 a month.
- Basic expenses are $1000 a month
- So net income is $3000 a month X 12= $36000 a year
- $200,000 divided by $36,000 = 5.5. This equals a CAP RATE of 5.5 %
- or roughly 6 years to what I call “payoff”
Generally anything with a payoff of 6 years or less is a decent investment unless you can get a higher interest rate for your money elsewhere, or the money you borrowed costs you more than 5.5%.
Appraisers use a variety of means and methods but they will use a more conservative model that includes the cost of debt service (if you bought the place with a loan…that interest and points on the loan).
At the end of the proverbial day, CASH FLOW is KING. What kills most deals is when real estate investors do not take this critical step to communicate with each other what they perceive as important, (how much cash do we need to generate each month?) and then add in a realistic time factor. Having your own personal version of a CAP rate helps you evaluate one property from another and quantifies in your subconscious "what is value?" so when you have to make a critical decision on purchasing one property versus another you can more clearly do so.