Joe Downs explains cap rates in self-storage investing: NOI divided by purchase price. He covers why cap rates fall when property prices rise, typical ranges by class, the spread between cap rate and interest rate, and how to use positive leverage to build wealth.
Chapters
All right, folks. Welcome back to day 51 of the Storage 100 series. Of course, I am Joe Downs with the Storage Mobiles Mass Run, and today we're finally demystifying cap rates. This concept is crucial for understanding any commercial real estate investment, really, and I'm going to break down what a cap rate is and why it matters to you. And at the end of the day, folks, it's simply a calculation that tells you a lot about a property's value and the associated risk. So let's dive into the core definition of cap rate. So what exactly is capitalization rate anyway, you might ask? Well, essentially it's your unleveraged return on investment, and we calculate it by dividing the net operating income or NOI by the purchase price. So for example, if a property generates $100,000 in income and costs $1 million, that's 10 cap, 10% cap rate. This formula gives us a quick snapshot of a property's income-generating potential. It's a fundamental metric for comparing different investment opportunities. So let's use an analogy to make the concept even clearer for you. Think of the cap rate like a thermometer, the thermometer for the real estate market. A low cap rate, say 4 to 5%, indicates a hot market with high prices and lower perceived risk. Conversely, a high cap rate like an 8 to 10% suggests a cold market with lower prices and higher risk. It's a direct indicator of both the demand for a property and the inherent risk associated with it. This analogy helps us quickly gauge market sentiment and investor safety at the same time. And understanding this relationship is key to making informed decisions, which leads us to the next point: understanding the inverse relationship between cap rates and property prices. So when cap rates go down, property prices go up and vice versa. And this means that in a competitive market, you'll see lower cap rates because buyers are willing to pay more. And then conversely, when cap rates rise, it probably signals that prices are falling. This dynamic is critical, critical for understanding the market trends and valuations. So with this in mind, then the next question is what constitutes a good cap rate? Well, what makes a good cap rate really good really depends on your investment strategy. So Class A stabilized properties, you might see cap rates between 5% and 6% because it's signifying lower risk, right? Class A property probably built in a good area, maybe brand new. Class B or C properties, maybe not so much, often considered maybe value-add opportunities. They typically have cap rates from the 6.5% to 8% range right now. For deep value-add or rural properties, which require a heavier lift, cap rates could be 8%, 9%, 10%, 11%, 12% or higher. Your ideal cap rate aligns with your risk tolerance and investment goals, but there's a common trap many investors fall into when looking at cap rates. And it's the difference between market cap and deal cap. And this is where many investors get fooled, and it all comes down to understanding the true numbers. So broker might tell you the market cap is a 6 cap, but when you run your own numbers, the deal might only be— the calculation of the cap rate might come out to a 4 cap. And this discrepancy often happens because the NOI presented by the seller or broker is inflated. So remember day 50 when we discussed how to spot a fake NOI? Yeah. You will always need to calculate the cap rate based on your own conservative projections and due diligence. Don't just accept the numbers given to you. Verify everything. This distinction is crucial because it directly impacts your potential returns and the true value of the investment. All right, let's take a look at another key metric, the cash-on-cash return, and how it differentiates from the cap rate. Because these are 2 distinct metrics. And understanding their differences is vital for making smart investment decisions. So the cap rate represents an unleveraged return. It's what you'd earn if you paid all cash for the property. So there's no debt, you owe no interest. We often use the cap rate when we're looking to sell a property. It reflects the market value without considering the debt. On the other hand, cash-on-cash return is a leveraged return, meaning we have debt. It shows what you're earning on the actual cash you invested after the debt service, after taking into account the debt. So it's NOI minus debt is what's left over, and that's your cash-on-cash return based on your investment. And this is a metric we focus on when we're buying a property, and because it directly reflects our own personal return on the investment. Both are important, and both— but they serve different purposes in your investment analysis. So knowing when to use each one or each metric helps you evaluate deals more accurately. All right. Let's dive into why the relationship between cap rate and your interest rate, or what we call the spread, matters so much. The spread is a critical indicator of a deal's financial health, and it's simply your cap rate minus your interest rate. So positive spread indicates positive leverage, meaning your cap rate's higher than your interest rate. This is what you want. Your property's— it means your property's generating more income relative to its value than what you're paying in interest. Conversely, a negative spread, also known as negative leverage, is where your cap rate is lower than your interest rate. This is a dangerous situation. That means you're paying more in interest than the property is even earning relative to its value. Always know your numbers and ensure you have a healthy positive spread. This concept, concept is fundamental to profitable real estate investing. With these financial tools in mind, let's look at a powerful closing thought and how to approach your investments. And here's your blueprint for success in self-storage investing, folks. This isn't about finding deals. It's about a strategic approach to building wealth. First, buy high, meaning target properties with a higher cap rate, which translates to a lower purchase price. Second, force the appreciation by fixing problems and raising the income through smart management improvements. And then third, sell low, meaning sell when the cap rate is low, which results in a higher sale price. This 3-step blueprint is a proven strategy for maximizing returns. It's what we do. It's about creating value, not just finding it. And this approach will help you build significant equity over time. All right, well, we've covered a lot of ground today, and I hope you've found this information valuable for your self-storage journey. Before we go, I do have a few requests for you. Please hit the like button if you found this helpful. It helps us reach more people. And subscribe to the channel so you don't miss out on future insights and strategies. Your engagement helps us grow and continue to provide valuable content. Remember, the more you learn and apply, the more successful you'll be. Thank you for joining me today, and please share this video with anyone you know who's serious about self-storage investing. They will thank you later.
