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Don't Take Cap Rates at Face Value

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When looking to purchase a multi-family building for yourself or when helping a client, how do you know which one is the best deal?

This presentation offers a broad overview of common CAP rate mistakes and is designed to show students situations where you should and should not use CAP rates to value multi-family
properties.
Before you read this presentation, be sure to read my blog post on this subject. https://gabhartinvestments.com/blog/2018/04/10/why-cap-rates-can-be-overrated/?et_fb=1

Published in: Real Estate
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Don't Take Cap Rates at Face Value

  1. 1. www.GabhartInvestments.com 858-356-5973 Presented by: CURTIS GABHART, CCIM Don’t Take Cap Rates at Face Value
  2. 2. www.GabhartInvestments.com 858-356-5973 INTRODUCTION Curtis Gabhart, CCIM • President, Gabhart Investments, Inc. • Director, Keller Williams Commercial • Has a Certified Commercial Investment Member [CCIM] designation from the CCIM Institute • CCIM San Diego Chapter Board Member • Past president Commercial Realtors Association • Commercial Policy Advisory Board – University of San Diego Burnham-Moores Center for Real Estate • Commercial broker for San Diego flip this house • 250 Million Plus of Commercial transactions • 40 + Million transacted personally • 2015 Multi-Family Dealmaker of the Year • 2015 Retail Dealmaker of the Year
  3. 3. www.GabhartInvestments.com 858-356-5973 Code of Ethics Article 11 of the National Association of REALTORS® Code of Ethics has this to say about expertise: “REALTORS® shall not undertake to provide specialized professional services concerning a type of property or service that is outside their field of competence unless they engage the assistance of one who is competent on such types of property or service, or unless the facts are fully disclosed to the client. Any persons engaged to provide such assistance shall be so identified to the client and their contribution to the assignment should be set forth.”
  4. 4. www.GabhartInvestments.com 858-356-5973 Questions We Hope To Answer • How can cap rates be inaccurate? • What are the some common pitfalls of using cap rates? • What are some alternatives to cap rates? • When do you use cap rates? • Case Studies
  5. 5. www.GabhartInvestments.com 858-356-5973 Cap Rates Blog Post • Before you read this PowerPoint, take a moment to get caught up to speed by reading my blog post on “Don’t Take Cap Rates at Face Value When Buying Your Next Multi- Family Building”. This article walks through many of the topics discussed in this presentation. Click here to read it
  6. 6. www.GabhartInvestments.com 858-356-5973 Consider This Scenario • You’re looking to purchase a multi-family building • You gather several perspective properties, gather the financial reports, and then sit down to decide which one is the best investment • How do you know which one is the best deal? • What metric would you run to right away?
  7. 7. www.GabhartInvestments.com 858-356-5973 What Is A Cap Rate? • The capitalization rate (cap rate for short) is the annual rate at which the property’s value is capitalized (paid off) by the year’s net operating income • In simple terms, it’s the unleveraged rate of return (as if you paid all cash)
  8. 8. www.GabhartInvestments.com 858-356-5973 The IRV Formula = 5% x $1,000,000 = $50,000 = $50,000 / $1,000,000 = 5% = $50,000 / 5% = $1,000,000
  9. 9. www.GabhartInvestments.com 858-356-5973 A Few Advantages/Disadvantages of Using Cap Rates Advantages Disadvantages Good to use in a stable marketplace Doesn’t reflect changes in market cycles Considers vacancy rates Single year snapshot of a properties performance Useful tool when used alongside other metrics Doesn’t consider market rents Widely-accepted valuation method and is routinely used by bank appraisers, county tax assessors, and commercial real estate brokers Is it based on last years, current, or next years NOI? (not always consistent) Can vary depending on how the current owner calculates/determines their expenses
  10. 10. www.GabhartInvestments.com 858-356-5973 Net Operating Income • Crucial component of determining a cap rate • Must subtract gross operating income from operating expenses to arrive at a cap rate • But what if the operating expenses are misreported?
  11. 11. www.GabhartInvestments.com 858-356-5973 Potential Rental Income Potential rental income (PRI) is the total of all rents under the terms of each lease, assuming the property is 100 percent occupied. If a property is not yet leased, PRI is based on market rents as determined from comparable properties. This is the first value to input into the NOI formula. Also known as Gross Scheduled Income, Gross Rental Income, Effective Gross Income.
  12. 12. www.GabhartInvestments.com 858-356-5973 Operating Expenses T-U-M-M-I • Taxes • Utilities • Management • Maintenance • Insurance
  13. 13. www.GabhartInvestments.com 858-356-5973 What are the Items Excluded from Operating Expenses? • Interest and principal on debt encumbering the property • Depreciation (cost recovery) • Income Taxes • Tenant Improvements • Real Estate Commissions
  14. 14. www.GabhartInvestments.com 858-356-5973 How Cap Rates Can Be Inaccurate?
  15. 15. www.GabhartInvestments.com 858-356-5973 How Cap Rates Can Be Inaccurate • Often times, small to mid-sized apartments don’t have actual expense reports or profit and loss statements from the owners • This could be because the owner/broker is: – Unorganized – Mis categorizing expenses – Doing repairs themselves and not factoring in things like labor costs – Labeling capital expenditures as maintenance expenses – Keeping incomplete expense reports or in some cases, no reports at all – Not adding property taxes, not adding property management fees, not using vacancy rates that the bank will use
  16. 16. www.GabhartInvestments.com 858-356-5973 Other Metrics To Look At Do any of these stand out when looking at comparable properties that would indicate that the cap rate is either too high or too low? • Gross Rent Multiplier – Apply standard income & expenses multipliers • Price Per Unit • Price Per Square Foot – Easier when comparing similar buildings with the same square feet size in the area • Gross Rents (Low or High?)
  17. 17. www.GabhartInvestments.com 858-356-5973 Gross Rent Multiplier The formula is: 𝑮𝑹𝑴 = 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑷𝒓𝒐𝒑𝒆𝒓𝒕𝒚 𝑮𝒓𝒐𝒔𝒔 𝑺𝒄𝒉𝒆𝒅𝒖𝒍𝒆𝒅 𝑰𝒏𝒄𝒐𝒎𝒆 (𝑮𝑺𝑰) Uses of GRM: • To quickly survey the market for opportunities (properties with a low price relative to market-based gross potential rent). • To value a property by using the GRMs of very similar properties within the same neighborhood or market area.
  18. 18. www.GabhartInvestments.com 858-356-5973 Gross Rent Multiplier What are the advantages of using GRM? • Very little information is required. • The required information may be obtained easily and quickly. • Within a homogeneous neighborhood or market area, most similar properties should have similar GRMs. • Investors may be fairly familiar with the GRM, but if not, they can grasp the concept quickly.
  19. 19. www.GabhartInvestments.com 858-356-5973 Gross Rent Multiplier What are the disadvantages of using GRM? The GRM does not take into account most relevant investment factors, such as: • Appreciation or depreciation in future value (FV) • Vacancy rate • Operating expenses • Financial leverage or mortgage amortization • Income taxes • Risk • Physical condition of the property • Potential upside due to below-market rents
  20. 20. www.GabhartInvestments.com 858-356-5973 Price Per Unit Price per Unit is a simple market benchmark, derived by dividing the price by the number of units. Cost per Unit = Price of the property / Number of Units What are the weaknesses of this Indicator?  The price per unit does not consider the following:  Property size  Type of units  Income  Physical condition
  21. 21. www.GabhartInvestments.com 858-356-5973 Price Per Square Foot The price per square foot is derived by dividing the price of the property by the square footage. What are the weaknesses of this Indicator?  The price per square foot does not consider the following:  Number of units  Type of units  Income  Physical condition
  22. 22. www.GabhartInvestments.com 858-356-5973 Other Things to Consider • Ask yourself where is the expense information that is provided coming from? Is the source reputable? • If its from a broker, have they been doing this for a while? Do they have a reputation for overstating expenses? • Do a smell test - if the rents are alarmingly high or low… you should be looking into the building. Price per square foot would be a much better metric in this situation • Remember, a CAP rate is what a seller/broker is trying to sell you on – what the property will one day be worth. As an informed buyer, you need to focus on what the property is worth NOW
  23. 23. www.GabhartInvestments.com 858-356-5973 Case Study 1 - Mr. Magoo • Owns a 12-unit apartment building in North Park • Amateur handyman • Does all maintenance and repairs himself – Patched leaky roof with plywood – Mixed left over paints – Saves thousands in labor and maintenance expenses • Manages building himself
  24. 24. www.GabhartInvestments.com 858-356-5973 Mr. Magoo Cont’d • You call about his property and he tells you that his expenses are very low and that the building is in great condition. He says the building has a 6% cap rate. • Without looking into the expenses further, you think this is a great deal.
  25. 25. www.GabhartInvestments.com 858-356-5973 Mr. Magoo Cont’d What’s wrong with this scenario?
  26. 26. www.GabhartInvestments.com 858-356-5973 Mr Magoo Cont’d • Don’t take his expenses at face value • His cap rate is false unless you plan to do all maintenance yourself and manage the building • The reason his cap rate is higher is because he didn’t factor in labor costs or market costs of maintenance and management • His expenses don’t represent what you, the new owner, would be paying
  27. 27. www.GabhartInvestments.com 858-356-5973 Case Study 2 - Miscategorizing Expenses • Say you find a 16-unit apartment building with an alarmingly low cap rate of 3.5%. Cap Rate of similar properties in the area is 4.2% • Upon further investigation, you find the current owner put down two consecutive years of electrical upgrades that cost $30,000 a year • That’s $60,000 in expenses for an electrical system that will last 50 years
  28. 28. www.GabhartInvestments.com 858-356-5973 Miscategorizing Expenses What’s wrong with this scenario? Amount % Potential Rental Income 307,200$ 100.0% Vacancy 9,216$ 3.0% Effective Rental Income 297,984$ Expenses Amount % Amount % Admin 3,000$ 1.0% Plumbing Repairs 2,900$ 0.9% Gas & Electric 7,200$ 2.3% Roof Repairs 2,700$ 0.9% Water & Sewer 18,000$ 5.9% Electrical Upgrades 30,000$ 9.8% Landscaping 2,400$ 0.8% Management (Off Site) 19,369$ 6.3% Trash Removal 4,800$ 1.6% Licenses & Fees 850$ 0.3% Pest Control 2,400$ 0.8% Insurance 5,200$ 1.7% General Maintenance 3,800$ 1.2% Property Taxes 48,000$ 15.6% Painting 3,600$ 1.2% Total Expenses 154,219$ 50.2% Net Operating Income 143,765$ 46.8%
  29. 29. www.GabhartInvestments.com 858-356-5973 Miscategorizing Expenses What is the purchase price of the property if the cap rate is 3.5%? Purchase Price = Net Income / Cap Rate = $143,765 / 3.5% = $4,107,000
  30. 30. www.GabhartInvestments.com 858-356-5973 Miscategorizing Expenses How can you correct the Net Income? • The owner should have spread the electrical expense over the life of the electrical upgrades • NOI should be $143,765 + $30,000 = $173,765 What is the Actual Cap Rate? $173,765 / $4,107,000= 4.20%
  31. 31. www.GabhartInvestments.com 858-356-5973 Case Study 3 - Property Taxes • Misreported property taxes can affect cap rates • Property taxes for multi-family buildings in San Diego is 1.2% of purchase price • Many sellers/inexperienced brokers/buyers will use old property taxes in their cap rate calculation • This is not accurate of what the new owner will be paying
  32. 32. www.GabhartInvestments.com 858-356-5973 Case Study 3 – Property Tax • Subject Property: 6-unit multi family building in Imperial Beach • Asking Price $1,249,000 • Net income is $68,000 • Cap Rate 5.50% • Operating Expense is $19,600 What’s wrong with this scenario?
  33. 33. www.GabhartInvestments.com 858-356-5973 Case Study 3 – Property Tax How much is the property tax the new owner will be paying? New Property Tax = Purchase Price x 1.20% = $1,249,000 x 1.20% = $14,988 *that’s already 76% of the actual expenses ($19,600) per the listing!
  34. 34. www.GabhartInvestments.com 858-356-5973 Case Study 3 – Property Tax Gross Schedule Income (GSI) $87,600 Operating Expense at 40% ($35,040) Net Income $52,560 What is the Actual Cap Rate? Actual Cap Rate = $52,560 / $1,249,000 = 4.20% Or if you buy at 5.50% cap rate, purchase price shall be $955K (not $1,249,000). That is $52,560 / 5.50% Cap.
  35. 35. www.GabhartInvestments.com 858-356-5973 Property Tax Example
  36. 36. www.GabhartInvestments.com 858-356-5973 So When Do You Use Cap Rates? • If you’re dealing with an experienced/reputable broker, looking at larger properties, or dealing with an organized seller who can convey accurate expense reports • Rarely when you get down to it, will the expenses be precisely what an owner says. The question becomes, “how far off is it?”
  37. 37. www.GabhartInvestments.com 858-356-5973 Cap Rate / GRM Matrix GRM 30% 35% 40% 45% 50% 55% 7 10.0% 9.3% 8.6% 7.9% 7.1% 6.4% 8 8.8% 8.1% 7.5% 6.9% 6.3% 5.6% 9 7.8% 7.2% 6.7% 6.1% 5.6% 5.0% 10 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 11 6.4% 5.9% 5.5% 5.0% 4.5% 4.1% 12 5.8% 5.4% 5.0% 4.6% 4.2% 3.8% 13 5.4% 5.0% 4.6% 4.2% 3.8% 3.5% 14 5.0% 4.6% 4.3% 3.9% 3.6% 3.2% 15 4.7% 4.3% 4.0% 3.7% 3.3% 3.0% 16 4.4% 4.1% 3.8% 3.4% 3.1% 2.8% 17 4.1% 3.8% 3.5% 3.2% 2.9% 2.6% 18 3.9% 3.6% 3.3% 3.1% 2.8% 2.5% Expenses
  38. 38. www.GabhartInvestments.com 858-356-5973 Final Thoughts The moral of the story is be careful when you rely on the CAP rates of small to mid-sized properties 1. Learn the market rents and expenses in your area so you can apply those metrics to buildings you’re analyzing 2. Learn other metrics – GRM, price per square foot, price per unit 3. Always conduct your own financial due diligence. Don’t take the seller/broker provided numbers at face value
  39. 39. www.GabhartInvestments.com 858-356-5973 More Information Interested in learning more about commercial real estate? Please visit our website www.gabhartinvestments.com/blog We have many blog posts that are designed to educate you on the various areas of commercial real estate
  40. 40. www.GabhartInvestments.com 858-356-5973 Thank you! Event Sponsors

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