Learning to Learn and Valuation Metrics: Installment 1: Cap rate
Learning to Learn and Real Estate Valuation Metrics
Learning to learn, always being open to new information, is a strategy that compounds in life, where as learning facts alone has limited upside, applicable only in a particular time and place.
It seems to me that this paradigm plays out strongly in the investment world. When we make investment decisions on a few pieces on information, focusing on only one or a few variables in any deal (for example, past history of the investment) it may work out for that particular deal if we are lucky, but long-term success requires a more wholistic approach.
Learning this myself as I evaluate more and more deals for purchase, I was reminded of an experience I had in my early medical education. Mid-way through medical school, my classmates and I left the classroom for the hospital and began to evaluate real, rather than imaginary, patients. Part of patient evaluation was based on the objective data provided by blood tests which are concentrations of different components of the blood represented by a number and units: A creatinine level of 0.9 milligrams per deciliter(mg/dL) would be one example of a commonly obtained lab test and value. The number is then judged against a standard as either normal or abnormal – too low or too high or just right.
What I discovered as I transitioned from imaginary to real patients is that isolated lab values do not help determining what is going on with patients. For example, creatinine in the blood increases when the kidneys are injured, but without context, the number itself tells us little about cause, therapy or likely outcome. For example, A 23 year old who just ran a marathon and comes to the ER for dehydration might have an elevated creatinine of 2.0 (normal about 1.0 or less) while a 63 year old who is seeing a physician for the first time ever, feels fine but has a blood pressure of 200/100, might also have a creatinine of 2.0. The young runner is likely to recover full kidney function with some intravenous hydration and an admonition to always hydrate while running in the future, while the 73 year old likely has permanent damage to his kidneys from long standing high blood pressure: his high creatinine signals a serious fundamental problem which needs to be addressed, and a less likely recovery of renal function.
I found myself thinking of this transition in my medical learning when I began to make use of the many metrics used to evaluating real estate value and returns. At first, I approached the subject the same way I had approached lab values early in medical school – trying to find meaning in the number itself, isolated from the context, trying to better understand the number rather than understand the property and what questions about the property need to be answered. What I learned in time is that in the same way a creatine blood level is meaningful only in the context of a particular patient, a real estate evaluation metric (CAP rate, cash-on-cash return, internal rate of return, etc.) are valuable only in the context of a particular property, at a particular time and often under estimated financial circumstances rather than actual.
For example, CAP rate is found by a simple calculation. Net operating income (the yearly profit after expenses) / value of the property. Easy enough, I thought at first. Calulate the yearly rental income, minus expenses like utilities, insurance and maintenance, and divide by the price and the higher the CAP rate the better, right? Well not really. Other questions pop up: How do I value the property? Is the value the asking price or the price you are willing to pay? Do you make a deal based on a cap rate at what it might sell it for in a few years? Do you plan on holding the property for cash flow or are you going to improve and re-sell? How risky is this investment compared to another similar investment? Are you solving for Cap rate, property value or expenses? In short, what question are you trying to answer for this property?
What I eventually learned is that these real estate metrics exist as methods to flush out a picture, to give a degree of objectivity to property evaluation that would otherwise be difficult to think or talk about. I have discovered that these metrics are very useful when used to answer well – formed and specific questions. Without the right questions, however, the calculations have limited value.
Thus, the key is to ask the right questions.
Over the next week I will discuss where I find meaning in three often used metrics: capitalization (CAP) rate, cash on cash return (COC), and internal rate of return (IRR), on more detail.
The Capitalization Rate. (Not Rate Cap!)
The capitalization rate, commonly referred to as "Cap Rate," is a fundamental concept in real estate investment. It is used to estimate the investor's potential return on a real estate investment. The Cap Rate is calculated by dividing the property's annual net operating income (NOI) by its current market value or acquisition cost. The formula is as follows:
Cap Rate=Net Operating Income (NOI)/Current Market Value or Purchase Price
NOI is the total income a property generates (such as rent) minus the operating expenses (excluding financing). The Cap Rate thus reflects the property’s natural rate of return in a single year, as if the property was purchased for cash.
(A ‘rate cap’ is an ‘insurance’ purchased on a floating rate loan that limits for a specified time period the maximum rate that an investor will pay for a loan, and has nothing conceptually to do with CAP rate. If I was the only person I knew to initially confuse these terms when learning about them, I would probably have kept my confusion to myself out of embarrassment, but I’ve heard others make the same mistake. So, if you are new to all this – I’ll acknowledge my rather embarrassing misunderstanding here in hopes of saving you one!)
The significance of Cap Rate in real estate valuation lies in its ability to provide a comparative tool for different real estate investments. Investors typically use it to assess the risk and potential return of properties. A higher Cap Rate generally indicates a potentially higher return but also higher risk, while a lower Cap Rate might suggest a less risky investment but with lower return prospects. This is very market dependent. Investors in Florida or Southern California are competing in a lower Cap rate market (properties are being sold with lower yearly profit relative to the purchase price). This implies a lower risk (due to expectation of more consistent long-term profit). While in other markets properties are selling at a higher cap rate, implying that there is more risk. Such risk might be the possibility of high vacancy, unexpected renovation or repair costs, or less projected appreciation in value.
Cap Rates are also type -specific. They vary depending on the type of property (like commercial, residential), and the current state of the real estate market. This variance makes them useful for comparing similar properties within the same category or geographic area. However when evaluating a particular deal, I have found that the cap rate I want to see is very specific to a property, geographic area and the business model. Though a city’s overall cap rate may be 6.0%, a property needing investment would likely require a higher cap rate to absorb unknown repairs, whereas a newly constructed and completely occupied property might be a reasonable buy at even lower than 6 cap rate, depending on the intent of the investor.
Cap Rate also fluctuates over time in the same market. As the environment which promotes or inhibits buying and selling changes, so does the value a property relative to the income it generates. This is reflected in changes of average market Cap Rates over time.
Cap rate can also be evaluated in relation the loan rate available for financing. The terms that refer to this concept are “positive leverage” or “negative leverage.” Positive leverage in real estate occurs when borrowed funds are used to purchase a property, and the investment generates a higher return than the interest rate of the loan. Negative leverage happens when the investment's return is lower than the loan interest, leading to diminished profits or potential losses. Essentially, positive leverage enhances returns, while negative leverage reduces them. If you are paying more for the money you borrowed than the return on the investment, you need to know that. Generally, this is not a great idea for those looking for cash flow from a leveraged property. On the other hand, someone (not me) with the funds to buy a property in cash may prefer the safety of a less risky return, and not need to buy at a Cap rate higher than going interest rates.
To summarize, Cap rate calculation can paint a picture from several different vantage points but does not determine ultimate returns.
Cap rate is usually used to inform:
Valuation and Comparison: Cap Rate allows investors to compare different real estate investments. Properties with higher Cap Rates are often perceived as potentially higher return (but higher risk) investments, while lower Cap Rates might indicate lower risk, but also lower return opportunities.
Assessing Market Trends: Cap Rates vary by geographical locations and property types. Tracking their changes can indicate shifts in the real estate market, helping investors identify emerging trends.
Investment Strategy: Investors use Cap Rate to align properties with their investment strategy. A high Cap Rate might suit those willing to accept more risk for potentially higher returns, whereas a lower Cap Rate might appeal to those seeking stable, lower-risk investments.
Risk Evaluation: While a high Cap Rate can suggest high potential returns, it also might indicate higher risks, such as property location, condition, or tenant stability.
Thus, the Cap Rate is a quick, widely-used metric for assessing the profitability and risk of real estate investments. It helps investors make informed decisions by providing a simple comparison between different properties and market segments and offering a quick, comparative measure of a property's profitability and risk profile. However, it should be used in conjunction with other metrics and a thorough understanding of the overall market conditions for a well-rounded investment analysis.
Next week I will discuss the metric Cash-on-Cash Return its significance in my property evaluations.
