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What Is A Good Cap Rate? How To Determine Your Cap Rate Formula | Mentorship Monday - YouTube
Channel: Derosa Group
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How do you make money on a property being
sold at a 5% cap rate?
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What's happening YouTube? It's Matt Faircloth.
Thank you for watching Mentorship Monday.
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My name is Matt. My company's called the DeRosa
Group and you guys are watching a segment
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we have called Mentorship Monday where people
email questions to [email protected].
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That is [email protected] and I answer
your questions right here on the YouTube channel
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for you and everyone else to learn from.
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Today's question comes from Dimitri, who is
right up the road in Lawrenceville. Shout
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out to Jersey, Dimitri. Welcome to Mentorship
Monday. Thanks for your question. Dimitri's
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question is simple. It's pretty straight up
really. "Hey Matt, when investing in condos,
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townhomes, single family homes, duplex people
are trying to get the 1% rule and the Holy
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grail 2% rule." That's funny. Well, anything
less than 1% rule is considered not a great
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investment. I find the 1% rule is actually
a breakeven, Dimitri, and above that is where
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you actually make money.
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Dimitri points out when it comes to multi-family
properties, that frequent selling properties
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at 5 caps, which would means that it's yielding
a half percent of the purchase price. Not
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exactly correct on your evaluation, Dimitri.
That's not how 5 cap works. The cap rate's
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not directly related to the rent coming in
on a property. You can't look at just a 5%
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cap rate and say that's a half a percent of
the percent rule.
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The way the 1% rule works is if you look at
a property and you say it's being sold for
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$50,000 per unit, that could be a $200,000
property as you have here, a $200,000 property
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being sold for four units. That's $50,000
a door. $50,000 a unit if the rents are $500
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per month per unit, that is the 1% rule. If
the rents are $1,000 a unit, that's the 2%
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rule for $50,000 per unit, right?
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The way cap rates play is I take that rent,
let's say it's a four family rented at $500
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a unit that's $2,000 and then I deduct out
expenses and let's say they're at a 50% expense
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ratio meaning that for every dollar that comes
in the door in rent, 50% of that rent comes
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back and goes towards expenses, the other
50% of the rent goes towards net operating
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income. That means I'm making $1,000 a month
or $12,000 a year in net operating income.
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That's not profit, that's not cashflow. That's
NOI. That NOI then needs to go pay my debt
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service and behind that is what I make in
my cashflow.
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But you take that NOI, then you divide it
by the purchase price, that gives you the
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cap rate. If you're at $12,000 per year NOI,
and mind you this is a super simple equation.
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I need my whiteboard to really do this the
right way because I could factor in vacancy
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and all of that kind of stuff. But bottom
line is you do all that and you're at $12,000
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over $200,000 in purchase price, which yields
a cap rate of 6%. That would be the cap rate
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on that deal. That's a 1% rule deal and that's
also assuming your expense ratio is 50%. But
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you have to factor in expenses when you factor
in cap rate, my man Dimitri.
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Now bottom line, getting all the way back
to your question because that's not even what
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you asked. You didn't even ask that, but you
did your math wrong and you're interposing
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cap rate and the 1% rule and I wanted to correct
you because a lot of people do that. Your
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question is how are properties sold at a 5
cap? Why would somebody even pay a 5 cap for
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a property?
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Well, here's the answer to your question,
Dimitri. Number one is it's a crazy high multifamily
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market, just bottom line. It's just a ridiculously
overpriced multifamily market right now. A
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lot of times people were selling stuff at
5 caps because they can and people are paying
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5 cap for a property because they have money
to put to work somewhere. Maybe they're doing
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a 1031 exchange and they just have money burning
a hole in their pocket or they went to one
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of the back of the room guru seminars and
they think they're going to make lots of millions
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of dollars in real estate by buying a 5% cap
rate property. Who knows, whatever it is there's
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a lot of people buying multifamily right now.
That's reason number one why properties are
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priced at a 5 cap is because there's buyers
at 5 caps, right?
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But the way that you can actually make money
on a property at a 5% capitalization rate,
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there are a couple of different ways. Number
one, let's say it is a strip center and it's
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at a 5% capitalization rate and it's a triple
net lease. Meaning the tenants pay all the
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maintenance, all the property-related expenses,
like real estate taxes and insurance and everything
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like that. Tenant pays all of that stuff.
You as the owner really only collect rent,
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which goes back toward your debt service.
That's it.
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If you're doing a deal like that, a 5 cap
might work because you don't really have any
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expenses beyond just your debt service on
the property. What the tenant pays in rent
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goes right into your pocket, so maybe the
5 cap works out that way because the expenses
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are very, very low in properties like that.
Maybe it's a new construction apartment building
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and the expenses are very, very low and proven
to be low and not 50% ratio, maybe there are
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30%.
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Those are ways that a 5 cap may work. Because
if you're borrowing money on the property
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and then you've got whatever you had to lay
down, you're making a cash flow and your NOI
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minus your debt service, maybe that cashflow
is ample for you, right? That's one way is
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low expenses. More likely what you're doing
is something called a value add play and 90%
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of people that are buying apartment buildings,
they're all talking about doing value add.
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Value add is a fancy way of saying, "I'm going
to go do stuff to the property which enables
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me to raise my rents or enables me to increase
the income of the property," which almost
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always means raising rent.
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You could do things to reduce expenses and
everything like that, but in big apartment
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buildings, the way the game is played is you
go and say, "I'm going to go put in new flooring
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and paint, new kitchens and new, new, new,
new, new, and a new playground and all this
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other kind of stuff," which we do. The DeRosa
Group does all that kind of stuff, so I'm
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familiar with it. You do it and you charge
more rent in exchange for the improvements
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that you made.
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That's called a value add play, where you
can take a property that's performing at a
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5 cap now and by increasing rents to cover
all those improvements that you're making,
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you might make the property end up at an 8%
or a 9% capitalization rate. Then you're making
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some real money, right? That is why people
buy properties at a 5 cap. Really, it's savvy
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investors buy property at a 5 cap is because
they see that they could invest in the property,
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make changes, come and tweak and make it a
good deal. I hear a lot of people say, "You
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don't buy a good deal. You make a good deal."
That's why people are really buy 5 caps because
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they see some way they can pluck the hair
off of it to make it a palatable property
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and it might not be now. That's really and
truly, Dimitri, why people buy a 5 cap rates.
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This is a long-winded Mentorship Monday, but
there's a lot of good nuggets in here. Thank
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you for you guys. It's taken to the very end
to hear all this. Thank you, Dimitri. Don't
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forget, [email protected] with your Mentorship
Monday questions. I appreciate you guys and
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have a great and profitable week.
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