If you want to get rich in investment real estate there’s a simple, and yet, often misunderstood concept you need to understand, and that’s CAP rate, pro forma CAP rate, and CAP rate compression.
I read an interesting article in Forbes magazine recently, “How The World’s Billionaires Got So Rich.” Not surprisingly, business ownership and real estate are at the top of the list.
If you’re a business owner, you need to expand your business, maximize profits and invest strategically.
What if you don’t own a business?
I know quite a few people who don’t own a business, but purchased rental and commercial real estate and have done exceptionally well. That is especially true for those who bought investment real estate in the past decade, in particular, those who purchased during or just after the depth of the 2008/2009 recession.
I also know many people who are interested in getting into investment real estate and are looking for pointers on what and how.
You’re interested in getting into investment real estate.
Where do you start?
I wanted to share with you a simple but often misunderstood concept that is the first three things you need to know when moving into the investment commercial real estate market: CAP Rate, Pro Forma CAP Rate, and CAP Rate Compression, and lower down in this article I will explain how to make lots of money in a compressed CAP rate environment.
Now, don’t get me wrong, finding an amazing income-producing property and then negotiating the financing and purchase of it takes a lot of work and skill, but before you begin the hunt, you need to understand a few important formulas first.
What is CAP rate?
At the heart of investment in real estate is a concept called CAP (capitalization rate).
For those who have read my book, “The Kickass Entrepreneur’s Guide to Investing,” I cover this in some detail, so you’re likely already familiar with CAP rate. For those who haven’t, I cover the basics of CAP rate, pro forma CAP rate, and CAP rate Compression below.
Following along with some of my calculations; I’m going to show you how an improvement of $1 in profit in your property can produce a $25 increase in your net wealth.
The CAP rate is the building’s profit, before taxes and building depreciation, divided by the purchase price of the building.
CAP Rate Formula Definition:
CAP rate Formula: CAP rate = Net Operating Income (NOI) / Building value (BV).
For example, say the real estate value of a building is $1 million. After expenses, the NOI, not including mortgage, debt repayment, or interest charges, but before taxes, is $60,000. The property’s CAP rate therefore is 6%: $60,000/$1 million=6%.
Now, how is the CAP rate formula, and CAP rate different from the pro forma CAP rate formula, and why is it important to focus on the pro forma CAP rate?
And the next question is …
How Do You Calculate CAP Rate?
You start with the revenues from the building. Include all revenues like rent collected, laundry, parking revenue. Subtract all expenses like hydro, insurance, taxes, maintenance, and management fees. The resulting number is called the Net Operating Income (NOI). Now, take that number, NOI, and divide it by the purchase price of the building.
** I created a Real Estate Investment Spreadsheet I’ve used for years, and have now made available for free. You can get more info, and download the spreadsheet, by clicking the red icon below.
What is Pro Forma CAP rate?
The pro forma CAP rate is similar to the formula for CAP rate, except, in the pro forma case, you include the repair costs to the purchase price of the building.
Let me provide an example.
Pro Forma CAP Rate Formula Definition:
Pro Forma CAP rate Formula: Net Operating Income after repair costs (NOI) / Building value (BV).
Using the example I provided above, the building is $1 million, and the building’s profit is $60,000. If the repair costs are $100,000, then the pro forma CAP rate is $60,000 / $1,100,000 = 5.45%
Notice that the CAP rate in the example is 6%, and the pro forma CAP rate is 5.45%.
The Importance of CAP rate and Pro Forma CAP rate
Why are these numbers so important?
All rental property trades on the CAP rate, so that’s the first thing a discerning buyer should look at when buying or selling a building.
CAP rates vary by city, neighborhood, pockets within a neighborhood, and current market conditions. A building in one section of a city can trade at a 4% CAP rate, while at the other end of the city a similar building can trade at 7%. Two blocks over, and you might be trading at 6%. So, although there is some subjectivity associated with the CAP rate, it’s quite defined.
At the moment, the average CAP rate of a multi-unit residential (MUR) building in North America is about 5.5%.
The average CAP rate in Toronto for commercial property, and multi-unit-residential (MUR) specifically, is about 3.5%. Similarly, the average CAP rate in Chicago, as a comparison, is about 5.5%. Whether it’s Toronto, or Chicago, or any other city, you need to research the going CAP rate based on the city, and area within the city.
Now let’s do some backward math to figure out the CAP rate. If I told you a building’s Net Operating Income (NOI) is $100,000 and the building has a CAP rate of 5%, we could determine the value as follows:
CAP Calculator = NOI/BV
5% = $100,000/BV
BV = $2 million
For the moment, we’re going to use CAP rate and pro forma CAP rate somewhat interchangeably, but, when buying a building, you need to understand the PRO Forma CAP rate number, which is probably more important from an investment perspective.
Although there are many ways to make money in investment real estate, here’s an example of how some creative math can make big dollars.
How to Make Money In Commercial Real Estate
Let’s say you were able to increase your building’s revenue by $1 (by raising rents), or lowering expenses by $1. Your net operating income for your building has now increased by $1. At a 5% CAP rate, for every extra dollar in Net Operating Income (NOI), you increase the value of your building by $20.
My Real Estate Situation and How I Made a Huge Profit
In 2014, I got a call from my insurance company about one of the apartment buildings I own. It happens to have 21 units.
It turned the insurance company no longer wanted to insure the building unless we removed the electrical knob and tube wiring from the apartments.
As an FYI, knob, and tube is an older style of electrical wiring that was used up until the early 1940s, and it seems that the insurance firms are no longer want to insure buildings that have knobs and tubes because of the increased electrical hazards.
The company gave me 4 weeks to fix the wiring, otherwise, we would have to find a new insurance company. They no longer wanted to insure my building.
Out of the two units, only 2 apartments had knobs and tubes, so, it wasn’t a huge issue, except, both units were rent-controlled occupied, meaning, I couldn’t kick out the tenants. I had to pay thousands to fix the wiring, patch the holes, and paint. If I added a few extra dollars, then I would have an entirely new unit.
These tenants were paying $900 per month each in rent, and the going rate for a completely redone apartment in the same building had a rent of approximately $1,500 per month, a $600 difference, or $7,200 per year.
I couldn’t kick out the renters, but, I could ask them to leave for 2 months while I retrofitted, but, because of rent control, I would have to give them their apartments back.
In the end, I paid the tenants thousands to vacate their units. When added in, including all upgrade fees, and vacancy fees to the tenants, I spent at least $45,000 to repair each unit. When I was done, the units looked awesome.
I had a 6¼-year payback:
Here’s the math: $45,000 in upgrades/$7,200 per year in rent increase=6.25 years.
At a 3.5% CAP rate, which this particular building is currently valued at, the $7,200 per year rent increase amounted to an increase of more than $205,000 in the building’s worth. Multiply that by 2 (there were two units) and in the end, I spent $90,000 and increased the building’s value by more than $400,000.
If I put the building on the market two days after construction completion and re-rental of the units, and the buyer would calculate the NOI based on the new rent roll.
The above explanation is why you need to understand the math behind commercial real estate. It’s how the REITs make money in real estate, and you can too. You need to understand the numbers.
Beware of the Negative CAP rate
Because of CAP rate compression, which I will explain shortly, it is possible to have a negative CAP rate.
How is this possible?
I’ve seen many situations where real estate listing agents purposely withhold some important numbers in the expenses, and ultimately the CAP rate calculation, which, if added in, will result in a negative CAP rate.
In the example I provided above, the CAP rate was 6% (or income of $60,000). Let’s say the building was in a low CAP rate environment, like Toronto, San Francisco, or New York (which also has low CAP rates) and the CAP rate was 2% (yes, there are many buildings with CAP rates that are low), leaving the building with a profit of 2%. The PRO Forma CAP rate is 1.8%.
Now, let’s say the listing agent left off maintenance fees, which isn’t uncommon, and perhaps repairs and maintenance. The income could be negative.
If these two expenses were $30,000 per year, then the income is now negative $10,000 per year, leaving the building with a negative CAP rate.
The above examples I provided, Toronto, and New York, are both examples of CAP rate compression.
Do You Want a High or a Low Cap Rate?
The general rule of thumb is, when you’re buying a building, you want a high CAP rate, and when you’re selling a building, you want a low CAP rate. There are some circumstances where, if you’re looking to purchase a building with rents well below market, renovate, and flip the units, you want a lower CAP rate. Remember, a building’s valuation is dependent on CAP, so, the lower the CAP rate, the better the return on the flip.
What is CAP Rate Compression?
CAP rate compression happens in rising markets where investors believe that prices will continue to rise. The higher prices rise, the lower CAP rates fall, which in turn, creates CAP rate compression.
Essentially, investors are paying more dollars for the same property without any underlying changes in the market, and as I covered above, as real estate prices increase, CAP rates go lower. This causes CAP rate compression, in other words, CAP rates get compressed, and the higher real estate prices go, the more the rates compress.
CAP rate and property value are inversely related. Now, buying real estate in a compressed market isn’t necessarily a bad thing … in fact, there are occasions where the lower the CAP rate, the better. Let me explain …
How Can You Take Advantage of CAP Rate Compression?
I’m going to go against the traditional investor belief that you need to always buy low, and sell high.
Yes, that is true, but, what if you can buy a property in a low CAP rate environment, like really low, and still make lots of money?
I wrote an article that goes into this in much greater detail. You can read this article, which explains which will provide an explanation, and there’s a synopsis below: Here’s How To Buy An Apartment Building And Make A Whopping 110% In Three Years
In a quick nutshell if you don’t want to read the article: the lower the CAP rate, and the more compressed the environment, let’s say 3%, for example, the more the upside potential that exists for you to purchase a property that needs work, improve the units, raise rents, and receive a large number of dollars in the upgrade.
Let me provide a quick illustration. For every $100 that you raise rents in a compressed 3% environment, you improve the value of your property, all other things being equal, by $3,333 ((100 / 3 X $100)).
So let’s imagine a scenario where you can raise rents on turnover of a unit from $1,000 to $1,500 per month, or $6,000 per year. That $6,000 with a compressed CAP rate of 3% will equate to $200,000 in increased property value. If you can do that multiple times in a building, perhaps one where rents are significantly below market, then you can make a lot of money.
If your building has 10 units, and you can make $200,000 per unit, then that equals $2 million.
Let’s say it cost $25,000 to do the unit upgrades. Then your return is: $25,000 spent on upgrades, $200,000 increase in value equals $175,000 return.
You give me a stock like that and I will buy it. Over and over and over again.
As many investors run from a real estate market with CAP rate compression, an astute investor will run into that type of market, upgrade the units, and flip the building for a quick profit. Your returns can potentially be huge, and I explain that in this article where I discuss the 110% return within three years.
As interest rates fall, investors look for yield and bid up real estate values, and that forces CAP rate compression as CAP rates fall.
Similarly, the opposite happens when interest rates rise. Investors move dollars into T-Bills and other secure investments, and risk assets are bid down, which forces real estate values to decline, and CAP rates to go up.
Remember, CAP rate compression isn’t necessarily a bad thing. You can use it to your advantage, as I explained in the 110% real estate return article I referenced above.
When reviewing REITs, you need to know that REIT managers are looking at the implied CAP rate.
What is Implied CAP rate?
The implied CAP rate is the NOI (net operating income) divided by the total aggregate value of the REITs market cap less its outstanding debt.
If you hear this term, implied CAP rate, don’t confuse implied CAP rate with CAP rate, or pro forma CAP rate.
I’ve written a number of articles on real estate investing which you can find here.
Hopefully, with these numbers in hand, and with some additional reading and research, you’re now in a position to invest in real estate.
Good luck with your real estate ventures.
Here’s a video that explains further:
Other Real Estate Articles I’ve written: