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Real Estate Math Video #14 - Capitalization Rate Real Estate (Cap Rate) | Real Estate Exam Prep - YouTube
Channel: The Real Estate Classroom
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hey everybody my name is paul pacheski
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and welcome to the real estate classroom
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youtube channel like always before we
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get started give this video a thumbs up
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hit that red subscribe button click on
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the notification bell comments questions
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down below that would be awesome in
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today's video
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it is part two in the final video on
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uh the entire appraisal series that
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we've been doing in today's video we're
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going to discuss
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the income approach to value using the
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capitalization
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method so let's get to today's video
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[Music]
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all right so the capitalization method
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or sometimes or commonly
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referred to as the cap the cap rate
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or the capitalization rate it includes a
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formula that you have to know
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for your real estate licensing exam and
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the formula is on your screen it's i
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divided by r equals value and that
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stands for the net
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annual operating income divided by the
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rate
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equals the property's value
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we use the capitalization method to
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value for
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larger properties commercial properties
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those type of things
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and and the cool thing about this
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particular formula
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is if you have two out of the three
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values you can calculate the third value
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so if you have the net annual operating
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income
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and you have the value you can determine
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the rate and
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and i'm going to show you some examples
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on how we do that
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and then i want to talk about the rate
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the capitalization
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rate because there's a lot of
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misconceptions
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out there when it comes to that term the
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rate is in
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the capitalization rate is actually in
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direct correlation to the level of
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risk uh which ultimately
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impacts the investors rate of return
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some people will say it's the rate of
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return and other people would disagree
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but
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it's it's all of those things and i'm
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going to explain what i mean in this
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video
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understand though primarily the
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capitalization rate
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is talking about the risk the level of
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risk of the investor
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and the lower the capitalization
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percentage
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the less risky the investment is
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the higher the cap rate the greater the
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risk is and let me give you an example
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let's say that you have a
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a property that's leased out to the
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department of motor vehicles it's a 25
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year lease
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it's going to have a lower
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capitalization rate because it's a lower
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risk
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versus if it's a let's say a gym
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where there's a lot more risk it's a
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shorter lease those type of things
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so there is a direct correlation between
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the risk
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and uh the rate it also impacts
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the the return on the investment for the
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investor
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uh certainly the higher the cap rate
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the more income you know so those are
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the things that we all take into
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consideration when you're using the cap
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rate and remember every investor
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they have different objectives and they
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can use the capitalization method
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to calculate those uh those objectives
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and i'm going to have some different
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scenarios here that i think will
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illustrate
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exactly what i'm talking about but i
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wanted to have the little discussion
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before we move forward about
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the rate itself all right so let's
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look at the formula we have the net
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annual operating income divided by the
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rate equals value number one
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the net annual operating income how do
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we calculate that
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now if you're buying an existing
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building we know that
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there's already going to have that
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historical data available to the
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potential buyer
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but for the purposes of those of you
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that are studying for your exam many
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times there are test questions where you
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kind of have to calculate the noi
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they'll give you all the information
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that you need
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but then you're going to have to know
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how to calculate that net operating
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so we take the gross annual income
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and we minus the or subtract
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the the annual operating expenses
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and that gives us our net annual
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operating income now what
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are considered operating expenses well
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that could be rents that could be
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uh leases lease fees and stuff on copy
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machines and postal machines it could be
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payroll
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it can be taxes it can be insurance
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anything
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that's an expense to run
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your business okay that is basically
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what an operating expense is so let me
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give you an example maybe this
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particular property
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has 50 000 in gross income from
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the leases that it it has and
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there's thirty five thousand dollars in
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operating expenses that gives us a net
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operating income
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of fifteen thousand dollars don't forget
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that's net
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annual operating income in our previous
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video where we talked about the gross
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rent multiplier that was gross
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monthly income and you have to remember
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the differences between the two
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approaches
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otherwise you're going to get any
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potential test question incorrect
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so capitalization method we use the
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net annual income all right let's go to
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step two here
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step two is now we determine the rate we
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already know if you look on your formula
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that we established that the net
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operating income is fifteen thousand
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dollars
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now what's the rate and where do we get
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the rate well
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it can come from a couple of different
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places and i know there's going to be a
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few of you that disagree but so uh
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give this video a thumbs down that'll
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still help my uh
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uh the channel grow so and i mean that
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sincerely there are some people that
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just they're so dogmatic about where
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this comes from it's not the rate of
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return it's the risk and other people
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will say no it's all about the
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the investor's objective i'm just going
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to tell you
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that it's used in all these methods that
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i have on your screen number one
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we get one way we can get the the
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cap rate or the capitalization rate is
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we can go into the community and find
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comparables that have already sold
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comparable properties uh that have
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recently sold in the area
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and then we do an analysis and we'll
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take the
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the property's net operating income
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remember net
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annual operating income and we divide it
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by the selling price
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and that will give you a cap rate that
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is one way
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another way is i've seen this where
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investors
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they have a minimum capitalization rate
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that they want because that's a direct
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reflection
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on the return on the money they're
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investing so the investor themselves
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dictates what that capitalization rate
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is going to be
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the third way to get that cap rate is
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there are services out there
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where uh that that commercial
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type real estate professionals can
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become members of
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and then regionally they will publish
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the capitalization
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rates within a region and also within
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a genre of business so they'll have the
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let's say for
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nebraska they'll have the
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the scale of the capitalization rates
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and
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for this type of property that's going
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to have a liquor store here is the
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average cap rate or
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if it's a government lease here is the
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average cap rate
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and and that way the appraiser can tap
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into that or the investor can tap
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into that as well so those are the three
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ways
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that uh that you get the cap rate
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or the capitalization rate for the
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calculation
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now i know the question is going to be
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well how do i know which to use and the
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answer is
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you won't and you won't need to the
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question is going to give you all the
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information on your exam
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that you're going to need to calculate
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the problem in fact typically they'll
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just say hey the capitalists are
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is the capitalization rate is this and
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the capitalization rate
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i'm sorry the net operating income is
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this so they're going to give you
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all the information that you're going to
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need to make the calculation
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right but remember the rate is a direct
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reflection of the risk
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the risk to the investor and that
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certainly does impact the investors
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return on their investment
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so we have the net annual income of 15
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000 in our little scenario here now the
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rate
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let's say we done some calculation or we
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looked in our book or
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or the investor minimum is 10 so now we
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have two out of the three values where
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we can get the third value
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so the noi the net operating income is
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fifteen thousand
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the capitalization rate is ten percent
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and how do we calculate that well
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it's real simple we take fifteen
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thousand
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divide it by ten hit the percent key
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and that's going to give the valuation
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of the property that's
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net operating income divided by the
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capitalization rate
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equals value that's essentially what the
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the formula is now remember i talked
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about two we can
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we can as long as we have two out of the
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three values we can get the third
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this is kind of a cool little thing to
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know too so
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let's say for example uh
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we have the value is let's say the value
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is given to us in the test question and
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then that net
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operating income we can now calculate
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what the rate is
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maybe the test question will give you
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the cap rate and the value or the list
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price
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and they're asking us to calculate the
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noi and here's how we do that
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so using our numbers that we've been
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using throughout this
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throughout this video let's say that the
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the net operating income
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is fifteen thousand and the list price
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is a hundred and fifty what's the
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capitalization rate
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now in where would we see this in a real
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life scenario
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so let's say that uh i'm looking at a
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property that i want to buy
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there's already a history and documented
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noi which is the net annual operating
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income and the property is at
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a hundred and fifty thousand dollar list
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price but maybe i'm an investor that has
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a
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specific minimum on the cap rate that i
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do not want to go below so i can
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take the information i know the list
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price i know what the historical noi
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is i divide those two numbers
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so we take that hundred and fifty
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thousand dollar list price and we divide
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it by fifteen thousand dollars
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and that should give us a ten percent
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cap rate that's again long as you have
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two out of the three
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another scenario gives us the
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capitalization rate is 10 percent
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and the property is listed for 150
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000 so what should the net
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annual operating income be so we're
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going to take that hundred and fifty
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thousand dollars and multiply
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it by 10 hit the percent key and when we
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do that that should give us
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the noi of 15 thousand dollars
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again it's just a way to calculate
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but notice one thing here in two
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scenarios we have to use
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division in one scenario we have to use
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multiplication and so you're going to
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have to remember that and commit this to
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memory
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you just have to that's the only thing i
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can tell you because you don't know
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which style
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or how they're going to phrase this test
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question regarding
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using the capitalization approach they
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may ask you for the net operating income
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they may ask you for the rate or they
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may ask you for
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the value the bottom line here is is if
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you know
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the formula and you know when and where
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you need to divide or multiply
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and you commit that to memory then quite
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frankly there isn't any capitalization
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type question that you're not going to
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be able to calculate for your real
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estate licensing exam all right if
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you're going to continue studying check
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out this video to my right
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it's a good one if you have not
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subscribed to our channel please do so
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click the little circle to my left other
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than that that's it i'll see you in the
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next video
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