ShmoopTube

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Finance allah shmoop what is capitalization rate Or cap rate

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and know it has nothing to do with the percentage

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of people wearing hats Cabaret is a pricing tool in

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the sale of commercial real estate Specifically it is calculated

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as net operating income divided by the property value Essentially

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kappa rate is like a price to earnings ratio or

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multiple but just applied to the unique foibles peculiar to

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real estate It doesn't necessarily apply to say a silicon

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valley software company Totally different metrics there like if a

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seller has a building that produces three hundred grand a

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year in n O I and they're asking for a

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five percent cap rate well it means that they're asking

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for six million bucks to sell you the building That

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five percent figure is like asking for twenty times and

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earnings like number in anna why they're in real estate

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land In essence this five percent figure implies the rate

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of return that the buyer of the building would get

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if they invested in everything else was held steady State

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like clients didn't leave a renter's didn't leave and pricing

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of rent didn't change And taxes and operations and maintenance

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and all your stuff didn't change And so on And

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the twenty times number that we just got there without

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was by dividing one hundred percent by five percent in

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that twenty So yeah no mystery here Anyway the figure

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here leaves out a ton of things Obviously things like

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how fully occupied the building is when you buy it

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and whether the building can or could or would be

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fully occupied versus some number less than they'll say that

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one hundred percent theoretical maximum occupancy today It also leaves

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out how much in upgrades and maintenance stuff the building

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needs at the diversity of its tenants I eat If

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the owner of the building's relying on one tenant to

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rent the entire building it's really risky Or if it's

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on one industry well it's really risky Versus having lots

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of different tenants in different areas of one industry dies

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or one company dies is not the end of the

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lease situation for the building And it also depends on

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the length of tenant lease is already in place in

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the building Like if all the leases come up or

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are finished in three months well you may have a

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problem you may have you know eighty two units or

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however big the building is too suddenly rent and it's

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good odds and the building stays empty for a while

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Italy certainly not one hundred percent capacity okay and also

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matters a ton in the pricing of a building whether

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the overall area like geographic area is appreciating in value

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and that rents khun b raised steadily for a long

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time or not Yeah chernobyl is a hot real estate

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market but you know different kind of heat And note

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The kappa rates are kind of an inverse bond ish

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calculation That is when kappa rates are high It means

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that the y multiple is low like an eight point

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two percent cabaret implies a roughly twelve times in a

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y price on the building A cap a rate of

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twenty percent implies on ly a five x multiple I'ii

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something is very very wrong with the building like it's

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losing it Zoning rights or needs t remove the s

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bestest in the roof Anyway the bigger the better idea

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here is that commercial real estate investors use better models

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than just this cabaret thing They also used discounted cash

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flow analysis to calculate the value of a building which

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totals the risk adjusted future stream of cash profits to

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the investors when they risk their own capital In buying

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the building that figure has to take into account the

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risk free rate iii the u S Government bond rates

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and then it adds risk or risk premium to those

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rates So if safe bonds are yielding three and a

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half percent today the added risk of buying that building

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might add another four percent a year in needed returns

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Such a cap rate needs to be at least seven

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and a half percent for the buying of the building

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Teo even make sense many many complications here So for

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the sake of clarity let's start with a better definition

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of eno iron net operating income You own this building

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It has one hundred offices all the same size which

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rent for ten grand a year each or rather one

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hundred percent aki given See here you have a theoretical

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maximum of a million dollars a year in rental income

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but today you're only an eighty percent capacity so you're

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only getting eight hundred grand and you have expenses Insurance

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Fifty grand janitorial service thirty grand heat water gas horning

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ran real estate taxes forty five grand and other service

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See things like fixing crap and mopping up goop on

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the ground when someone bet wrong on the stock market

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and uh you know pays their debts a different way

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you know twenty five grand So then on eight hundred

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grand in revenues the building has one hundred seventy k

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year in operating expenses so that's eight hundred minus one

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seventy That's six hundred thirty grand in profits And we're

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done right No Why Well because almost all of real

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estate carrie's dead often lots of debt In any rational

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wall street investment you'd include cash and debt on the

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balance sheet That part of the valuation methodology here right

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But why wouldn't you in real estate Well because the

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depth of pockets varies so much among fires some will

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pay all cash and then refinanced the optimized tax deductions

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on their own Others will just assume debt already in

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place on the existing building like they'll just take over

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the payments to that bank that's already made alone So

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in order to not cloud the value of the operating

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cash flows of the building most real estate Investors use

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cap rates just to figure out the operating part and

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then they add in and back out the dead and

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interest on that debt and other investor related costs subsequently

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Yeah so yeah that's capitalization rate which in tax written

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by a thirteen year old yeah is nearly always zero 00:05:33.705 --> [endTime] percent

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