Don't Take Cap Rates at Face Value

www.GabhartInvestments.com
858-356-5973
Presented by:
CURTIS GABHART, CCIM
Don’t Take Cap Rates
at Face Value

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INTRODUCTION
Curtis Gabhart, CCIM
• President, Gabhart Investments, Inc.
• Director, Keller Williams Commercial
• Has a Certified Commercial Investment Member
[CCIM] designation from the CCIM Institute
• CCIM San Diego Chapter Board Member
• Past president Commercial Realtors Association
• Commercial Policy Advisory Board – University of San Diego
Burnham-Moores Center for Real Estate
• Commercial broker for San Diego flip this house
• 250 Million Plus of Commercial transactions
• 40 + Million transacted personally
• 2015 Multi-Family Dealmaker of the Year
• 2015 Retail Dealmaker of the Year

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Code of Ethics
Article 11 of the National Association of REALTORS® Code of
Ethics has this to say about expertise:
“REALTORS® shall not undertake to provide specialized
professional services concerning a type of property or service
that is outside their field of competence unless they engage the
assistance of one who is competent on such types of property or
service, or unless the facts are fully disclosed to the client. Any
persons engaged to provide such assistance shall be so identified
to the client and their contribution to the assignment should be
set forth.”

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Questions We Hope To Answer
• How can cap rates be inaccurate?
• What are the some common pitfalls of using
cap rates?
• What are some alternatives to cap rates?
• When do you use cap rates?
• Case Studies

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Cap Rates Blog Post
• Before you read this PowerPoint, take a
moment to get caught up to speed by reading
my blog post on “Don’t Take Cap Rates at
Face Value When Buying Your Next Multi-
Family Building”. This article walks through
many of the topics discussed in this
presentation.
Click here to read it

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Consider This Scenario
• You’re looking to purchase a multi-family
building
• You gather several perspective properties,
gather the financial reports, and then sit down
to decide which one is the best investment
• How do you know which one is the best deal?
• What metric would you run to right away?

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What Is A Cap Rate?
• The capitalization rate (cap rate for short) is the annual
rate at which the property’s value is capitalized (paid off)
by the year’s net operating income
• In simple terms, it’s the unleveraged rate of return (as if
you paid all cash)

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The IRV Formula
= 5% x $1,000,000
= $50,000
= $50,000 / $1,000,000 = 5%
= $50,000 / 5% = $1,000,000

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A Few Advantages/Disadvantages
of Using Cap Rates
Advantages Disadvantages
Good to use in a stable marketplace Doesn’t reflect changes in market cycles
Considers vacancy rates Single year snapshot of a properties
performance
Useful tool when used alongside other
metrics
Doesn’t consider market rents
Widely-accepted valuation method and is
routinely used by bank appraisers, county
tax assessors, and commercial real estate
brokers
Is it based on last years, current, or next
years NOI? (not always consistent)
Can vary depending on how the current
owner calculates/determines their
expenses

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Net Operating Income
• Crucial component of determining a cap rate
• Must subtract gross operating income from operating
expenses to arrive at a cap rate
• But what if the operating expenses are misreported?

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Potential Rental Income
Potential rental income (PRI) is the total of all rents
under the terms of each lease, assuming the property is
100 percent occupied. If a property is not yet leased,
PRI is based on market rents as determined from
comparable properties. This is the first value to input
into the NOI formula.
Also known as Gross Scheduled Income, Gross Rental
Income, Effective Gross Income.

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Operating Expenses
T-U-M-M-I
• Taxes
• Utilities
• Management
• Maintenance
• Insurance

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What are the Items Excluded from
Operating Expenses?
• Interest and principal on debt encumbering the
property
• Depreciation (cost recovery)
• Income Taxes
• Tenant Improvements
• Real Estate Commissions

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How Cap Rates Can
Be Inaccurate?

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How Cap Rates Can Be Inaccurate
• Often times, small to mid-sized apartments
don’t have actual expense reports or profit and
loss statements from the owners
• This could be because the owner/broker is:
– Unorganized
– Mis categorizing expenses
– Doing repairs themselves and not factoring in things like labor costs
– Labeling capital expenditures as maintenance expenses
– Keeping incomplete expense reports or in some cases, no reports at all
– Not adding property taxes, not adding property management fees, not using
vacancy rates that the bank will use

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Other Metrics To Look At
Do any of these stand out when looking at comparable
properties that would indicate that the cap rate is either
too high or too low?
• Gross Rent Multiplier
– Apply standard income & expenses multipliers
• Price Per Unit
• Price Per Square Foot
– Easier when comparing similar buildings with the same
square feet size in the area
• Gross Rents (Low or High?)

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Gross Rent Multiplier
The formula is:
𝑮𝑹𝑴 =
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑷𝒓𝒐𝒑𝒆𝒓𝒕𝒚
𝑮𝒓𝒐𝒔𝒔 𝑺𝒄𝒉𝒆𝒅𝒖𝒍𝒆𝒅 𝑰𝒏𝒄𝒐𝒎𝒆 (𝑮𝑺𝑰)
Uses of GRM:
• To quickly survey the market for opportunities (properties with a low price
relative to market-based gross potential rent).
• To value a property by using the GRMs of very similar properties within the
same neighborhood or market area.

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What are the advantages of using GRM?
• Very little information is required.
• The required information may be obtained easily and
quickly.
• Within a homogeneous neighborhood or market area,
most similar properties should have similar GRMs.
• Investors may be fairly familiar with the GRM, but if
not, they can grasp the concept quickly.

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What are the disadvantages of using GRM?
The GRM does not take into account most relevant investment factors, such
as:
• Appreciation or depreciation in future value (FV)
• Vacancy rate
• Operating expenses
• Financial leverage or mortgage amortization
• Income taxes
• Risk
• Physical condition of the property
• Potential upside due to below-market rents

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Price Per Unit
Price per Unit is a simple market benchmark, derived by
dividing the price by the number of units.
Cost per Unit = Price of the property / Number of Units
What are the weaknesses of this Indicator?
 The price per unit does not consider the following:
 Property size
 Type of units
 Income
 Physical condition

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Price Per Square Foot
The price per square foot is derived by dividing
the price of the property by the square footage.
What are the weaknesses of this Indicator?
 The price per square foot does not consider the following:
 Number of units
 Type of units
 Income
 Physical condition

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Other Things to Consider
• Ask yourself where is the expense information that is provided
coming from? Is the source reputable?
• If its from a broker, have they been doing this for a while? Do
they have a reputation for overstating expenses?
• Do a smell test - if the rents are alarmingly high or low… you
should be looking into the building. Price per square foot
would be a much better metric in this situation
• Remember, a CAP rate is what a seller/broker is trying to sell
you on – what the property will one day be worth. As an
informed buyer, you need to focus on what the property is
worth NOW

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Case Study 1 - Mr. Magoo
• Owns a 12-unit apartment building in North Park
• Amateur handyman
• Does all maintenance and repairs himself
– Patched leaky roof with plywood
– Mixed left over paints
– Saves thousands in labor and maintenance expenses
• Manages building himself

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Mr. Magoo Cont’d
• You call about his property and he tells you
that his expenses are very low and that the
building is in great condition. He says the
building has a 6% cap rate.
• Without looking into the expenses further, you
think this is a great deal.

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Mr. Magoo Cont’d
What’s wrong with
this scenario?

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Mr Magoo Cont’d
• Don’t take his expenses at face value
• His cap rate is false unless you plan to do all
maintenance yourself and manage the building
• The reason his cap rate is higher is because he
didn’t factor in labor costs or market costs of
maintenance and management
• His expenses don’t represent what you, the
new owner, would be paying

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Case Study 2 - Miscategorizing Expenses
• Say you find a 16-unit apartment building with an
alarmingly low cap rate of 3.5%. Cap Rate of similar
properties in the area is 4.2%
• Upon further investigation, you find the current
owner put down two consecutive years of electrical
upgrades that cost $30,000 a year
• That’s $60,000 in expenses for an electrical system
that will last 50 years

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Miscategorizing Expenses
What’s wrong with
this scenario?
Amount %
Potential Rental Income 307,200$ 100.0%
Vacancy 9,216$ 3.0%
Effective Rental Income 297,984$
Expenses Amount % Amount %
Admin 3,000$ 1.0% Plumbing Repairs 2,900$ 0.9%
Gas & Electric 7,200$ 2.3% Roof Repairs 2,700$ 0.9%
Water & Sewer 18,000$ 5.9% Electrical Upgrades 30,000$ 9.8%
Landscaping 2,400$ 0.8% Management (Off Site) 19,369$ 6.3%
Trash Removal 4,800$ 1.6% Licenses & Fees 850$ 0.3%
Pest Control 2,400$ 0.8% Insurance 5,200$ 1.7%
General Maintenance 3,800$ 1.2% Property Taxes 48,000$ 15.6%
Painting 3,600$ 1.2%
Total Expenses 154,219$ 50.2%
Net Operating Income 143,765$ 46.8%

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What is the purchase price of the property if the
cap rate is 3.5%?
Purchase Price = Net Income / Cap Rate
= $143,765 / 3.5%
= $4,107,000

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How can you correct the Net Income?
• The owner should have spread the electrical expense over
the life of the electrical upgrades
• NOI should be $143,765 + $30,000 = $173,765
What is the Actual Cap Rate?
$173,765 / $4,107,000= 4.20%

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Case Study 3 - Property Taxes
• Misreported property taxes can affect cap rates
• Property taxes for multi-family buildings in
San Diego is 1.2% of purchase price
• Many sellers/inexperienced brokers/buyers
will use old property taxes in their cap rate
calculation
• This is not accurate of what the new owner
will be paying

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Case Study 3 – Property Tax
• Subject Property: 6-unit multi family building in Imperial Beach
• Asking Price $1,249,000
• Net income is $68,000
• Cap Rate 5.50%
• Operating Expense is $19,600
What’s wrong with
this scenario?

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How much is the property tax the new owner will
be paying?
New Property Tax = Purchase Price x 1.20%
= $1,249,000 x 1.20% = $14,988
*that’s already 76% of the actual expenses ($19,600) per the
listing!

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Gross Schedule Income (GSI) $87,600
Operating Expense at 40% ($35,040)
Net Income $52,560
What is the Actual Cap Rate?
Actual Cap Rate = $52,560 / $1,249,000
= 4.20%
Or if you buy at 5.50% cap rate, purchase price shall be $955K
(not $1,249,000). That is $52,560 / 5.50% Cap.

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Property Tax Example

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So When Do You Use Cap Rates?
• If you’re dealing with an experienced/reputable
broker, looking at larger properties, or dealing
with an organized seller who can convey accurate
expense reports
• Rarely when you get down to it, will the expenses
be precisely what an owner says. The question
becomes, “how far off is it?”

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Cap Rate / GRM Matrix
GRM
30% 35% 40% 45% 50% 55%
7 10.0% 9.3% 8.6% 7.9% 7.1% 6.4%
8 8.8% 8.1% 7.5% 6.9% 6.3% 5.6%
9 7.8% 7.2% 6.7% 6.1% 5.6% 5.0%
10 7.0% 6.5% 6.0% 5.5% 5.0% 4.5%
11 6.4% 5.9% 5.5% 5.0% 4.5% 4.1%
12 5.8% 5.4% 5.0% 4.6% 4.2% 3.8%
13 5.4% 5.0% 4.6% 4.2% 3.8% 3.5%
14 5.0% 4.6% 4.3% 3.9% 3.6% 3.2%
15 4.7% 4.3% 4.0% 3.7% 3.3% 3.0%
16 4.4% 4.1% 3.8% 3.4% 3.1% 2.8%
17 4.1% 3.8% 3.5% 3.2% 2.9% 2.6%
18 3.9% 3.6% 3.3% 3.1% 2.8% 2.5%
Expenses

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Final Thoughts
The moral of the story is be careful when you rely on the
CAP rates of small to mid-sized properties
1. Learn the market rents and expenses in your area so
you can apply those metrics to buildings you’re
analyzing
2. Learn other metrics – GRM, price per square foot,
price per unit
3. Always conduct your own financial due diligence.
Don’t take the seller/broker provided numbers at
face value

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More Information
Interested in learning more about
commercial real estate? Please visit our
website www.gabhartinvestments.com/blog
We have many blog posts that are designed
to educate you on the various areas of
commercial real estate

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Thank you!
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