How To Invest In Real Estate | What Is CAP Rate? - YouTube

In your journey, in learning how to invest in real estate.  Eventually, you're going to run across the word CAP rate.  

What is CAP rate? What does it mean?  What is the definition of CAP rate?

and how do you arrive at a CAP rate by formula? We're going to talk about that in the next episode.

In your journey to learn how to invest in  real estate, you're going to run into the  

words CAP rate. Let's talk about it, so you're not  standing there flat-footed scratching your head.  

So we're talking about the words CAP rate. What is the definition of CAP rate?  

Why is it good to understand CAP rate?  and what is the math behind the formula  

to arrive at a CAP rate? That's what  we're going to talk about right now.  

CAP rate is an income expense calculation, that lets you know how much a property is bringing in  

based on the NOI. So let's break this down. NOI stands for "Net Operating Income", and NOI is all  

the expenses but you do not include the debt service. Because basically, you have to look at  

the property and say, "What expenses are inherent  to this property?" The electric bill, the property  

has to have electric that's part of the property.  But debt service is not the property's fault that  

you didn't have the cash to buy it, it's not the  property's fault. So we don't include debt service  

in the NOI calculation of income and expense. Just the expenses that are inherent to the property.  

Electric, water, lawn maintenance, roof maintenance,  you know whatever is inherent to the property.  

Again, it's not the property's fault that you had  to borrow money to buy it. So all that's left to do  

to find out the value of this property by its  cash flow is to plug in what you invested in  

the property, or what the cash amount for that  property would have been to buy it. But we'll get  

to the math in a minute, I'm going to give you a  real example with real numbers and it'll be clear. 

The reason it's important to understand CAP rate  is every commercial real estate investor and every  

commercial real estate broker and agent out there,  is speaking about the CAP rate of the property  

that they're talking about. It's almost goes  without saying, that if they're going to tell you  

about a property they're going to tell you what  the CAP rate is. So you need to understand that,  

CAP rate is a way of figuring out an ROI, a return  on investment based on the NOI, the net operating income.  

So it's really important that you get it because,  once you understand CAP rates. You can kind  

of get a real sense of value for a property, as far  as its cash flow is right now, today. And then see,  

if it appeals to you or doesn't appeal to you. Or if you want to look in further to that property to  

see if you can change the CAP rate by increasing  rents or decreasing expenses whatever. But that's  

what CAP rate is about, it's about sizing up a  property's cash flow and that's why you need  

to understand it. Now, before I give you that case  study as I promised just a minute ago. I'd like for  

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where this came from. So the math is easy enough,  all you have to do is put the formula together  

with the right numbers. But that's the key, you have  to pick the right numbers to put into the formula.  

So, I'm going to throw out a hypothetical situation,  a hypothetical deal we're going to plug in some  

hypothetical numbers and I'm going to show you how  you arrive at a CAP rate. Now, some of these numbers  

we throw out will not be numbers you'll want to use,  and that's why I'm putting the example the way I am.  

So let's say we have a property and they want  $500,000 for it it's for sale,  

they want 500,000. Let's say the debt  on it is $250,000, and this  

property is throwing out $92,000 a year in income. But it has $42,000 

worth of expenses, plus $22,000 worth of mortgage payments  

or debt service on it. So, what is the CAP rate if  we're going to pay $500,000 

for this property and how do we arrive at the  CAP rate? Let's take a look at that formula.  

So the formula goes annual NOI divided by cash sales price, equals CAP rate.

So let's go back to the beginning,  annual NOI it brings in 92,000 it has 42,000  

expenses plus 22,000 in debt service, which is an  additional expense to the owner. How do we get to  

the NOI, the net operating income would be 92,000  minus 42,000. You're not going to include the 22,000  

for the debt service, because that's not in the  definition of NOI. It's not that property's fault  

that this man had to borrow money to buy it. That lives $50,000 of NOI. So you take  

$50,000 per year and divide it  by $500,000 and you come up with a  

10% CAP rate. People are being going around  town saying, "Hey, you want to buy this property for  

500,000 it has a 10% CAP rate?" You can automatically go well, that means it's making about $50,000  

a year if they're selling it for 500,000, and  that'll give you a place to start right off the bat.  

We have a feel for what this property might be  worth given the numbers they're telling us.

Don't ever believe the numbers anyone tell you. Always do your own research, but at least we have a field.  

Now, I want to caution you here. We never believe  the numbers that other people deliver to us.  

We will trust, but we need to verify. You'll find  a lot of times the numbers that they're bringing  

to you are not right. I would especially check out  those expenses and I would especially go through  

that income with a fine-tooth comb. A lot of times,  people trying to sell something have their own  

agenda and they're not really worried about what  position it puts you in once you buy it from them.  

So let's do a little bonus round here and talk  about how you might look at all these numbers  

and the NOI and change things. Or figure out a  way to change the expenses in such a fashion  

that it makes sense for you to buy this property.  Right now, you're not into spending $500,000 

just to make 10% on your money. You have to have a bigger number.

Personally, I have to have a bigger number than that. So, I would start looking at the expenses and maybe   

I would notice in these expenses out of that $42,000 worth of expenses. There was  

$18,000 in those expenses for  property manager. Well, I have a property manager  

built in-house and I'm already paying them. So, property management's not going to cost me a dime more.

So, I can take $18,000 out  of those expenses, out of those $42,000

worth of expenses and see what my NOI looks like now. Because I don't need property  

management, I already have it and I'm already  paying for it. That'll push your NOI up from

50,000 a year to 68,000 a year. Now, let's do the  math at 68,000 annual income divided by 500,000  

worth of cash investment. What does that make the  CAP rate? Will, it makes the CAP rate 13.6%?  

and that's a long way from 10%. So, the question is,  is it good enough for you to go ahead and buy?  

Or do you need to negotiate with the seller down  from 500,000 to 475,000 to push this CAP rate to  

15 or 16 or 17 percent. And all of a sudden, we're starting  to get the basis for a negotiation and why we're  

doing what we're doing. It's up to you, to know  where to draw the line. But now that you've figured  

out how you can mitigate some expenses and that  you're going to have to negotiate a little bit  

with the seller to come down, so you can up that  CAP rate even more. But you just at some point  

have to draw the line and say, "If he doesn't sell  the property to me for "X", then I'm walking away".  

I don't buy properties unless I make "X" CAP rate  or I make "X" percent rate of return.  

And, so you figure out what price the seller has  to sell it to you for, for that to be true,

and either he does or he doesn't. The most powerful  person in a negotiation is the person who doesn't  

care one way or the other. And in this case, if I'm  looking at this property for example it would be.  

You know, if he wants to come down to my price. I'm very interested if he doesn't, next and move along.  

I'd like to sincerely thank all of you  for staying with me through this episode  

and the explanation of CAP rate. I would  like to give you a copy of my book,  

My Life & 1,000 Houses: Failing Forward to Financial Freedom. All I ask is that you pay the $7 in shipping & handling.

Also, I'm going to include a free video  on my seller finance strategy,  

and I will show you how I've used that  strategy to become financially independent, and  

maybe even wealthy in some people's book. Just go  to the link 1000houses.com scroll up  

and down that home page. There see all the free  stuff I have and find the free book choice and  

click on it, and you'll be on your way. Alright, I'm out of here see you in the next episode