Friday, January 13, 2012

Capitalization Rates

I've taught this so many times - I decided to write a quick tutorial on capitalization rates here so anyone can access this information easily.

Income (i.e. Rents)
Less Operating Expenses - real estate taxes, insurance, maintenance (all expenses except personal income taxes)
Equals: Net Operating Income

This is the cash flow you would get if you bought a property for cash before paying your personal income taxes.  Ideally you'd be smart enough to buy the property in a IRA or Roth IRA and not have any personal income taxes.

Net Operating Income divided by Total Investment equals your Cap Rate.  Total investment includes the acquisition of a property plus renovations.   A high cap rate is better than a low cap rate assuming all other things are equal.

But there are many other things we can use cap rates for.

You can use cap rates to "see" where a market is.   A market that has 25% cap rates and very low interest rates (cost of money) is a market that is emotionally in FEAR.  That market just got through with a major devaluing of real estate and investors have a sick/visceral feeling in their guts that prevent them from taking advantage of amazing opportunities.

A market that has 6% cap rates and the cost of borrowing is running at 10% is a market that has been going up and investors are cocky- they think the market will go up indefinitely despite the fact that it doesn't make economic sense.     This is a market you should be selling it despite the GREED factor of thinking "this thing is going up every day - I'd hate to get out too early."

You might want to make a BIG NOTE that most investment decisions are made in the GUT not in the head but by using cap rates you can possibly make better decisions with your head.

You can also use cap rates to make a better decision.  If an investment/improvement in your property costs $1,000 and saves $500/year, is it a good deal?  Well, using a 10% cap rate that improvement will raise the value of your property $5,000!!!!  Sounds like an amazing deal to me.   But without using that analysis it might not look like such a good deal.  $500/.1 = $5,000.

As a practical matter there is no sense in calculating an exact cap rate.  When I am standing in front of a building that I am evaluating I run the numbers quickly in my head.

$1,000 Rent (brain says $12,000 in income IF everything goes right)
Tenants pays utilities (brain says expenses will be between 30% of gross and 50% of gross depending on the answer to this question, the local real estate taxes and the condition of the property).  Say $4,000 for the sake of this conversation.
(brains says $8,000 Net Operating Income)
Real estate broker says: $50,000.  (Brain says maybe buy for $45 plus $5 in improvements)

Calculate:  $8,000/$50,000 - 16% Cap Rate

If my cost of money (borrowing) is 10% this might be a deal.

If my cost of money is 18% I know I would lose money every month.

Friday, January 6, 2012

The Roller Coaster

What your perspective on the likelihood of an economic/real estate recover is probably very indicative of the fact that you are a human being. When the markets are up 99% of people think it will NEVER go down. And when the markets are down most people think it will NEVER recover. But if you look at any graph of any market you'll see something very different. Extremely low prices ALWAYS eventually stimulate buying. And the momentum almost ALWAYS goes too far. And the cycle completes itself.

Human beings have a very very short and myopic memory. The fact of the matter is, if you use a financial model it is always very obvious where the market is. I use Capitalization Rates. When "cap rates" are high (i.e. prices are low) I can buy and hold and make money regardless of what the market does or how long it takes to recover. When cap rates are low and don't make any sense it is good time to sell but I don't have to sell - I still continue to profit from the day to day cash flow of the property. 

In the end, for most people though it is like riding a roller coaster. Most people only know where they have been and the visceral feeling of where they have been is their emotional governor and they literally have no choice but to yield to their feelings. A financial model is a "theory" and the visceral feeling of falling (or rising) is way more "real" and overrides good judgment. But you do not need an MBA from Harvard to know that it is a good idea to buy when yields are 20% plus and sell when prices are so high that the same asset is yielding 5%. Yet most people respond just the opposite because of the visceral effect.

Now lets see how you good your choices and thinking are. Time will definitely tell!