There are a lot of complicated definitions of a Capitalization Rate (CAP rate for short). They are interesting, but mostly irrelevant. Let me give you an easy to understand way of relating to and thinking about a CAP rate.
If I (or anyone) purchased an income producing piece of real estate (say self-storage), what would my cash on cash return be in year one (the first 12 months). It’s that simple.
Formula: Income – operating expenses = net operating income (NOI)
NOI/Purchase Price = CAP Rate
The term gets bantered about so much because that is the way investors, appraisers, and owners determine the value of an income producing real estate asset. All income-producing real estate is valued by taking the gross income the property generates (rent), less the operating expenses (taxes, maintenance, utilities, insurance, etc.). That number is called net operating income (NOI).
Theoretically, the rate of return that a ready, willing, and able buyer is willing to pay for that income stream (CAP rate) determines the value of the asset. In my book, Creating Wealth Through Self-Storage, I used the following example to help explain this concept.
Take two different income-producing properties: (1) a low-income, tax credit housing property, and (2) a “Triple Net Leased” (NNN) retail building with an AAA-rated public company as the tenant. (NNN means the tenant pays all the expenses, including taxes and insurance, making the rent the NOI for the owner). In this example, both properties generate a $100,000 NOI. The market CAP rate for the NNN property (i.e., what ready, willing, and able buyers are willing to pay for that $100,000 income stream) is 7%. In other words, for a relatively hassle-free, relatively safe income stream, the market is willing to pay someone a price that would generate a 7% return (calculated by dividing $100,000 by .07). That places a value of $1,428,571 for that $100,000 income stream if the income is generated by a NNN retail building with an AAA-rated public company as the tenant.
The low-income tax credit example, which has more risk, more management issues to deal with, and a less secure income stream, may require a higher rate of return by the market. A property of that type may command a 12% return (CAP rate). Therefore the value of that asset would be $833,333 ($100,000 divided by .12). Same $100,000 NOI, but the CAP rate used will determine the value.
However, NOI and cash in an owners pocket are usually vastly different amounts. In the real world, most investors do not pay all cash for their investments. When was the last time you did? On a spread sheet, below the NOI line, is the rest of the story. That includes the loan payment and any capital expenses (such as new roof, tenant improvements, paving, etc.), the owner makes in a year.
What happens “below” the NOI line is what determines the ultimate yield of a real estate investment over time. For example, in the same two properties above, if the low-income tax credit housing requires $30,000 for capital improvements in a given year that leaves a net $70,000 cash flow for that year. The NNN property requires no capital improvements (or if it does, the tenant pays, so it is no expense to the owner). Therefore net income (NOI) for that year would remain $100,000, but distributable cash to the owners is much less. The less variable expenses “below” the NOI line on a profit and loss statement, the more accurately one can predict the yield and cash flow of a property over time.
Low-Income Tax Credit Housing Example
Rent Income $200,000
Operating Expenses $100,000
NOI $100,000
Capital Improvements $30,000 (tenant improvements, commissions, etc.)
Distributable Cash Flow $70,000
NNN Leased Property Example
Rent Income $100,000
Operating Expenses $0
NOI $100,000
Capital Improvements $0 (tenant pays)
Distributable Cash Flow $100,000
This is why self-storage is the best investment (or as I might say when I am wearing a suit and tie), “the best real estate asset class” to invest in. Below the NOI line in a self storage investment, there is just debt service most years. In self-storage there are few capital improvements required. There are no commissions and no tenant improvements. (No carpet, no plumbing fixtures, and no walls to potentially re-construct every time someone moves out). There are very predictable and schedulable capital expenditures (paving, new roofs, etc.). The net income stream (NOI) can be projected very accurately and, with few variables pulling against it, the NOI and the distributable cash (except for the loan payments) are very close. It looks on paper very much like a NNN lease property.
I hope this helps with CAP rates, how they are used, and why self-storage is the best investment there is.
UPDATE: For more information on how the smaller self storage investor can use CAP rates, please see this Episode.
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