What is a Capitalization Rate? - Real Estate Basics - YouTube

Hey, everybody is Ken again, so let's talk about capitalization rate and so what?

Usually it's called is a cap rate.

And the great thing about a cap rate is there's only two things

that are in a cap rate.

The first thing is your annual NOI or net operating income.

And I'm going to talk a little bit about that.

But that's basically the net cash.

So think of it this way.

If you've got let's say your paycheck comes in and you get three grand a month

and your expenses are two grand a month, you're inoi is one grand a month.

That's why it's just the difference between income and expenses.

And then the cost of the property, whatever to that is.

And that's your capitalization rate.

The interesting thing about capitalization rate is it's an important barometer,

but it's not always what you use to invest.

In other words, is it kind of tells you which way the market's going.

So before we get there, I want to talk to you a little bit about what an NOI is.

So there's only a couple of things with an nowy.

You've got your income, which is typically, let's say

for me, I'm heavy in the multifamily space.

It's my resident's coming in and paying rent or other income, you know,

for different things that might be in a multi-family unit for a self-storage.

You know, it's storage fees for a flower shop and selling flowers.

You know, it's that if for a subway shop, it's, you know, selling food

for for a for an office building, it's a tenant

paying rent, you know, and renting space for an office.

So it's all the income category that whatever it might be.

Now, the thing that can manipulate the income would be vacancy rates.

So depending on where you want, we are in the market cycle.

You know, income could be high, could be really strong, occupancy

could be really high. So all those things are going on.

And so income is a big piece of your net operating income.

The expenses are, of course, everything that you would think about.

So expenses would be marketing costs and utilities and property

taxes, insurance and payroll and management fees, all that stuff. OK.

And so you have a personal net operating income.

Your businesses definitely have a net operating income.

Your investment properties definitely have a net operating income.

And guess what? The US government has a net operating income.

It's called GDP, our gross domestic product.

So so these are all things that you need

to get familiar with if you're buying real estate.

And so as we start to look at this net operating income here,

you can see that it's whatever the property is pulling in,

divided by the cost of that property on whatever it is that you pay.

So that is how you determine the cap rate.

So let's just walk through one example.

So we know that it's income minus expenses.

And what you want to do when you're buying a piece of property is you want to look

for properties that have income that you can grow. In other words.

The last thing you want to do is buy at the top of the market

or you want to buy something where the rents are

the highest or the prices are the highest. I mean, it's just common sense.

Same thing with a car.

You know, you want to try to buy something at a good price

while you're doing the same thing.

And it's all the costs are usually based on this income.

And you also want to take a look at spots where you can actually

save on the expenses,

because if you can grow your income and save on your expenses,

then you're going to grow your net operating income, and that's

how you're going to grow the value of the real estate.

So let me just walk you through some real life examples.

So here is a building

that we paid, let's say, one million dollars for,

and it has a net operating income at

of one hundred thousand dollars.

So if you take the one hundred thousand dollars into

and you divide it by the one million that you paid, then you've paid

what's what's called a 10 percent cap rate or capitalization rate. OK.

That's how it works.

Here's the cool part.

What we're trying to do here, guys, is we're trying to increase this.

So how can you grow the net operating income?

So there's a lot of ways and that's the secret

sauce of investing, in my opinion,

because what we're trying to do is grow this. And why?

Because as you grow the NOI then you grow

the value of the property at the same time.

So, for example, maybe this property has one hundred

thousand dollars in NOI, but it's got, let's say, 30 percent vacancy

right now, for example. OK.

So if you could increase that vacancy.

Or if you could increase that occupancy down

and get that down to 10 percent, let's say, then for sure,

because your expenses are pretty fixed, your income's going to go up,

so you might grow this to one hundred and twenty and NOI or 130

NOI, depending on the rents are what they are inside of that building.

So that's the whole game here is you want to try to buy these

at the right cap rate and you actually want to

to to to sell them at a low cap rate.

So we have this term in the industry

when you're buying is what's your exit cap rate?

Because you want your exit cap rate

to be a lot lower than the cap rate that you're buying.

And that's the most important thing of everything I've said.

You want your cap rate to be higher when you buy

and your exit cap rate to be lower. If you do sell.

So thank you very, very much.

If you guys are interested, we go into a lot more detail on this in my

in my videos on KenMcElroy.com

And you can see all kinds of information on the NOI and the

and how to calculate it and how to grow the NOI and,

of course, how to buy correctly and to maximize your cap rate.

So, again, thank you guys very much for listening.