03: How Cap Rates Change And Using Them In Valuation

Wealth Formula Nation,

Welcome back to our weekly wealth widget. Last week we defined capitalization rate aka “cap rate”. To review, cap rate=NOI/Purchase price. Cap rate can also be seen as the yield of a given asset without leverage.

How is cap rate used practically speaking? Well, markets typically have a market cap rate which is determined by comparable properties sold in a given area. For example, let’s say the historical cap rate of multifamily C class properties in Dallas Fort Worth is about 7.5. That means, that over the last several decades the average yield on a significant C class property without a mortgage would be 7.5% annualized.

“What? 7.5%? No way, Buck! I’m not seeing anything in that market at better than a 6.5 cap”. I know that’s what some of you are thinking. Of course, the key term I used was “historical”. Right now, cap rates are lower than normal is most major markets. That is what we call “cap rate compression”. For the most part, this is a cyclical phenomenon. Cap rates go up and they go down in a given market.

There are many things that influence cap rates but certainly interest rates are one of them. Interest rates have been at historical lows over the past few years. Why would interest rates affect the market cap? Well, think about it in terms of buying your own house. If you own a house you know that your payments go towards principal and interest. If interest rates are lower, your payments are lower and you can afford more house. The same thing goes for larger assets. The lower the interest rates, the lower the monthly debt payments on a given property. If debt payments are lower, you can pay more for an asset, right? So, that drives up the price of the property sale price. Of course, cap rate does not take into consideration debt so simply increasing the purchase price in the equation cap rate=NOI/Purchase price will decrease the cap rate. RIght? After all, NOI is the same. So, lower interest rates generally drive DOWN cap rates. Similarly, as interest rates go up, we would expect cap rates to go up (decompress).

A couple more things about cap rate. As we discussed, cap rates dictate the value of larger assets. In other words, valuation is based on an equation (cap rate=NOI/Purchase Price), not by subjectivity. A single family house is worth what someone is willing to pay for it, not by an equation. That’s one of the reasons I like owning larger assets. The valuation allows you to “force” equity. What that means is that you can increase the value of the property by improving the numbers. If we rearrange the previous equation to Purchase Price=NOI/Cap Rate and assume the cap rate as a constant variable, you can see that you can increase the value of a property by increasing NOI. NOI again is simply Revenue-expenses without a mortgage. So, if you make some improvements and increase rents, you can increase the value of the property. Similarly, decreasing expenses by running a property more efficiently will also increase NOI so that will also result in an increased value of the asset. So… when you here the term “value add opportunity” that is referring to the opportunity to increase the value of an asset by either increasing revenue, decreasing expenses, or both.

Hopefully that makes sense. If not, feel free to reply with questions. These are critically important concepts.

Have a good weekend,

Buck