FCP 065: Understanding Cap Rates – How To Make Sure You Get The Best Deal On Property

Jack: Hey, Jack Bosch here, and welcome to the Forever Cash Life Real Estate podcast. I’m super excited about this subject that we’re going to cover today. Today, we’re going to talk about this subject of understanding cap rates. Cap rates is a term that’s being used in real estate very loosely, and very few people actually know what it means. So we’re going to shed light on that. What does cap rate mean? And how does it relate to NOI, Net Operating Income? All right, so with that, let’s get started right after this little message.

Man: Welcome to the Forever Cash Life Real Estate Investing podcast with your host Jack and Michelle Bosch. Together, let’s uncover the secrets to building true wealth through real estate and living a purpose-driven life.

Jack: Okay, here we are, we are back and as promised, I wanna talk to you about cap rates. But before, I wanna explain quickly, again, the name of our podcast because several people ask me. “Why do you call it Forever Cash? What does Forever Cash mean?” Forever Cash means cash flow that comes in for the rest of your life. So, therefore… And if you have the cash flow that comes in passive income, enough passive income into your life, then you have a life of abundance, a life where you have freedom of time and freedom of money. And therefore, you can start focusing on the other two freedoms, which are freedoms off relationships and freedom of purpose, and use that time and that money to do the things that really matter in your life. So it’s about Forever Cash and it’s about your life, and that’s why it’s called the Forever Cash Life Real Estate Podcast. And why real estate? Because real estate is the vehicle that Michelle and I have chosen to reach our own financial goals, to reach our own Forever Cash lifestyle.

And along those lines, I wanna talk about one of the vehicles that we use for our Forever Cash lifestyle, which is multifamily investing. And multifamily investing means apartment complexes, right? An in-depth terms of apartment complex investing, there is one term that’s constantly being mentioned that very few people understand yet it’s being used all the time, and that is cap rate. So what does cap rate me? Well, cap rate means basically that capitalization rate, I guess, right? So that doesn’t really help you, right? I get it, I get it. So what I wanna say by that is, in one way to think about cap rate is the percentage of the value of a property that comes out as cash flow at the end of the day, right? So the cap rate is basically what the property spits out in percent compared to what it ideally usually sells for. So, therefore, here’s the thing or what it’s worth, so, therefore, when somebody sells a property for, let’s say…somebody sells a multifamily property for $1 million. Let’s do a different example, let’s say $10 million. So they wanna sell it for $10 million and that property spits out $1 million a year in net operating income, that’s the other term, right?

Net operating income is the second term we’re gonna talk about and I will define it in a second. But basically, that’s just the sum of it, that’s the income of the property, what it net throws off after paying for all the overhead and expenses, and management and things like that. So after pacing it up, after paying that stuff, it’s throwing off $1 million a year. So if somebody sells a property that throws off $1 million a year for $10 million, then the $1 million represents 10% off that $10 million sale price, and therefore they’re selling it what’s industry…in the industry being referred to as a 10 cap. So that’s a 10 cap, a property that sells at 10% off the sale price or off the asking price, right? So, therefore, now, if this property, if they want to sell this property at a…if this property would sell for $10 million, but the net operating income would be at $500,000, well, $500,000 is only a 5% off the $10 million. So in that case, that seller is gonna want a 5 cap. So basically, if you think about that, a seller is always going to, if we turn this around, if you have a property that spits out $1 million, and that seller that the person who owns this property wants to sell this property at the 5 cap, then the sale price needs to be so high that $1 million represents 5% of the sale price.

So in other words, what is…? $1 million is 5% of what? It’s 5% of $20 million, right? $20 million, $2 million is 10%, $1 million dollars is 5%. So, therefore, if you have a property that throws off $1 million in cash flow a year, and the seller says, “I wanna sell it for 5 cap,” that means he wants to sell it for $20 million. If that the seller says, “I wanna sell it at a 10 cap,” that means he’s gonna want to sell it for $10 million. So in other words, for a seller, if the seller wants to sell a property at a low cap rate because that means that it’s a high multiple off that net operating income, and hope that makes sense, right? So the lower the cap rates, the higher the price is of the property. Because if you look at an offering, so you go to a broker or you go on LoopNet where deals go to die, I understand, but you can still play with it, you can look at the deals there, usually they’re not very good deals. But if you look at LoopNet, you look at some deals and they see what they ask, they’re saying like they give you the net operating income and they give you the cap rate that they want. With that you can calculate what the asking price is. Because if the income is a million dollars and they say they want a 5 cap, then you can say, “Well, basically a million dollars divided by 5% equals 20%.” It’s a simple mathematical calculation, you’ll really solve for the unknown, which is the asking price.

If they say, “Oh, well, I wana sell it for 6 cap,” well, then it’s a different number, like 18 million. If they sell at 7 and ½ cap, it’s $5 million, if they wanna sell it at a 10 cap, it’s $10 million. So the higher the seller is willing to sell, the higher cap rate they’re willing…the seller’s willing to go, the lower the price he’s willing to sell for because the net operating income is what it is. But if a seller wants to sell, he doesn’t change the net operating income, he changes the price. And with the price, it changes the percentage that that net operating income represents off that sale price, so that’s one way to look at it. But in essence, if somebody says, “Hey, I want to 10,000…,” and you can do this the other way around, if somebody says, “Hey, I want $20 million for my property.” And you ask them, “Well, what’s the cap rate?” And they tell you 5%, then you can immediately say, “Okay, the net operating income off that property is $1 million. Because they basically told you, “I want 20,” and the net operating income is 5%, because net income is, you know…because that relationship exists. I hope you understand what I’m saying, right?

So, therefore, if they say $10 million and they’re selling it at a 10 cap, then you say, “Then we know that the income of that property,” that’s the best way to explain it, the income of that property is 10% off the sale price. So if he wants 10 million and he’s selling at a 10 cap, then we know the income is a million. If he wants 20 million and he wants a 5 cap, then the income is also 1 million. If he wants 10 million and he wants to sell it at a 5 cap, then the income is only $500,000. So you can always solve for the unknown, if you have the other two. I hope that makes sense. So that’s one way of looking at it. Now, let’s turn this thing around. So or First of all…so when you go to a seller, the seller is gonna want to get the lowest possible cap rate because the income is what it is. So if the income represents a lower percentage of sale price, then the sale price needs to go up for that to make sense. So as a result now, a seller, therefore, keep in mind, the seller wants to get a low cap rate. As a buyer, of course, you want to buy the opposite way, you want to buy with a high cap rate.

Because if you have a property that has a million dollars in net operating income that you wanna buy, do you wanna buy it at the 5 cap, or a 10 cap? Right, 5 cap or a 10 cap? Well, you wanna buy it at a 10 cap because if you buy it at a 10 cap, you’re buying it for $10 million, if you’re buying it at a 5 cap, you’re buying it for $20 million. So you as a buyer, you want to buy as at high as a cap rate as possible. But remember, just at paper, if you ask somebody about the situation, right now, they tell you, what is the cap rate on the property, they basically tell you, “Well, how much do you want for the property?” Ten million is like at what cap, 10%, you know, the property makes a million dollars. So this is, kind of it’s hard to understand a little bit because cap rate is the percentage that the property throws off based on a value. And that value is either the market value or what they bought it for, or what they asking for. So when you go in as a buyer of a potential apartment complex, you want to see…you want to look for properties that have a high cap rate because that means that compared to what the property spits out, the selling price is low. That’s really what it means.

A high cap rate means that compared to what the property spits out, the selling price is low. So when you buy a property at a 20 cap, and it throws off a million dollars, then it’s basically that the sale price is only five times, it’s only $5 million, it’s only five times that amount. At a 20 cap…or 5 cap, it’s 20 times because it’s the multiple, it’s another way for the multiple. So I hope this is not too confusing here because I’m, kind of, mixing different concepts. Now on the buying side, though, so that, therefore, the discussion is always, “What are you gonna buy the property at?” And some people are really stuck to the cap rates, the cap rates at the same time, doesn’t mean that much. So we just bought an apartment complex, which we really bought at a 6 cap. Now, a 6 cap remember, a six cap is a fairly low cap rate and that means we paid a fairly high price for that property. But we did that because of the overall situation in the property, that the owner was running this property way too expensive, had way too many people working there, had way too much as money spent that the…too much vacancy, had some other things that the rents were too low.

So based on the reality on the ground, this property was making something like $290,000 a year, they’re paying for almost $5 million for it. So basically, we’re paying…that is an almost…so 5… $280,000, $290,000 represents 5.9% off the sale price that we’re willing… over the purchase price that we’re willing to pay for the property. However, this is based on screwed numbers. Because if you know that you can increase the revenue of the property by $200,000 or $300,000, and that you can decrease the cost of the property by $50,000 to $100,000, you know that you’re opening yourself up to a substantial net operating income increase. So, therefore, just the net operating income doesn’t mean always something, just the cap rate on its own doesn’t mean something on it, it needs to be looked at in the great scope of where the property’s positioned compared to other properties in the market. Now, I know it’s getting a little bit more complicated. But here’s the thing, the net operating income is what the property spits out after subtracting from maintenance costs, marketing costs, staff costs, basically leasing office, property management costs, repairs, and property taxes, as well as insurance.

So you’re really… All the operating expenses that you have to pay are subtracted from it. Really the only thing that is not subtracted from it, is really capital expenditure items. So stuff that you use to actively improve the property because they’re not ongoing expenses. And the other thing, you don’t necessarily…you don’t exclude or you don’t include is actually payments to the bank, those are separate. So it’s what the property spits out as you run it from a day-to-day operation over the course of one year, that’s the annual net operating income. And then the asking price is a multiple of that, right? And it’s basically… So, if the asking price represent…or if the net operating income represents 5% of the asking price, then really, the seller’s asking for twentyfold increase or 20-multiple of that cash flow. And if you’re asking for a 10 cap, it’s a 10-multiple of that, and if it’s a 15-multiple, it’s a 7 and a 1/2 cap, and so on and so forth. So basically, it stands in that relationship to each other. So, therefore, it’s very important, the easiest way though to remember it, the very much easiest way is to just basically say, “In a situation of as us without negotiation, that the cap rate is the percentage that the property spits out based on a certain value given to the property, either an asking price, a sale price or an appraisal or so.”

All right, if an appraisal comes in and appraises the property at $5 million and it spits out $500,000, then you can say this property based on appraised value operates at a 10 cap because it’s appraised at $5 million, and it throws off $500,000, that is 10% off the asking price, right, or off the value. If a sale price comes in, “I wanna sell it for $5 million, it spits out $500,000,” then they’re asking for a 10 cap, right? And if you’re going with an offer, and you want to buy this property at a 10 cap, then you can go ahead and say like, “Well, I need to buy it at a 10 cap, if it throws a $500,000 I’m offering you $5 million,” even if they might want $6 million. So this is the easiest way to think about it, the cap rate is the percentage off what a value that is asking about a price, sale price or appraised value, whoever, different people pick different of these values and then the percentage of that that the property spits out, that is your cap rate. So when we run the property, to finalize this, I’m always telling people, “We’re buying this at the 6 cap.” But based on a $5 million purchase price over two years, we’re going to operate the property at a 9 or 10 cap, that means we have almost added 50%, more than 50%, of income to the property.

Then based on the purchase price that we paid, the property now, we bought it at a six gap so it spits out 6% off the purchase price but within a year or two, we have it operating and spitting out 9% per year off the purchase price. And then after five years, we have it operating at 11% or 12% off the purchase price and then we’re gonna go and sell it. And ideally, what do you wanna sell it? Do we wanna sell it at a 12 cap? No, because then we would sell it at the same price. We would sell it based on the doubled income, we would sell it at the same cap that we bought it, the 6 cap rates which really means we doubled the value of the property. I hope that makes sense, it might have been a little bit complicated at the end but if you understand, if you read up on that a little bit, it’s a very interesting concept. It is really only three numbers, it’s a price, purchase price usually or asking price, it’s a percentage and that leads you to a…or it’s a net operating income and those two stand in a relation and that relation is the cap rate. All right?

With that, thank you very much. That’s the piece I have right now. Make sure, if you’ve enjoyed that… If you have questions about it, right? Put them below the video right now if you’re watching this on YouTube. If it’s on iTunes, make sure you go over to our Facebook group called Forever Cash Club, also called My Open Path. But Forever Cash Club, it’ll pop up, you see there’s a bunch of members in there, several thousand. Go in there, join the group, ask your questions, they’ll be more than happy to answer questions. And then, also if you watch and listen to this on iTunes, make sure you give us a five-star review. And if you’re interested about knowing more about this or investing or so, just go to, what is that, jackbosch.com/income and you can actually fill out the little form there, and talk to us about learning more about what we do in the apartment complex investing area. All right? With that, I say hello. I already said hello. With that, I say goodbye and see you in the next show.

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