How to Calculate Cap Rate - Analyzing Real Estate Deals

So I'm going to compare and contrast the two of them to help you better analyze your real estate deals. So let's get into cap rate and we're going to go to the whiteboard and just talk about the basic cap rate calculation. Now it sounds really easy on the face of it, and it is, but it gets to be a little tricky. Now the cap rate is your noi, net operating income. Write it off to the side. Debt, operating income, that's rent minus the direct cash expenses, not depreciation. Cost sags, blah blah blah. So it's net operating income. I'll do an example. You take net operating income divided by the purchase price in some way, say all cash in. Like all I cash in. What did I cost? And you're gonna have closing costs maybe, and maybe you budgeted for some improvements. But when all your cash is in, noi divided by purchase price equals your cap rate. That's how it works. And so when you go to analyze multi unit deals, commercial deals, realtors, brokers will be like, okay, here's the cap rate, here's the cap rate. And on the face of it you're like, okay, that helps me. But it's only a starting point because, and let's do an example here. So let's say we go whiteboard, we go with a $1 million purchase price and let's say that there is 100,000 a year in rents and you might have an adjustment for reserves, but this is your gross rent. What is my rents coming in min, 30,000 in expenses. These are direct expenses. And I have 70,000 of net income. You may say, well, is this your taxable income? No, because I'm going to write off home, office and travel and dining and computers, electronics and auto and all these goodies. And I may even write off a bunch of depreciation. Of course you will. So your taxable income is going to be different. So here we're just looking at your net operating income. I put in a million dollars and I pay my direct expenses. No debt, no debt. I'm going a cash deal. What's my noi? So let's look at that again. So we got my 70k. So that is 7%, 70,000 divided by the $1 million that equals my cap rate. Okay, now let's put some debt on top of this because in fact, let's talk about this. A real savvy commercial multi unit investor is trying to do one main thing. They're trying to create additional equity in the property exponentially. And how they do it is by changing two variables. If I can increase rents by 5% or more and I can decrease expenses by 5 to 10% or more because of economies of scale. You know what you're doing and you're like, hey, I can, I can therefore increase my net income because the net income is exponentially going to increase the sales price. So having a 5 or 10% change here at this level might increase this, and then 4, increase the net, and then on a 4x or 5x type scenario, increase the purchase price dramatically. So I might create, oh, let's say $20,000 more of income, net income. Well, that might have a $200,000 impact on value. So it's almost like a 10x. And it's going to vary and everybody has a different way of looking at it. But the point is a good investor is trying to really increase that NOI over an 18 to 24 month period when they take over a property and then get it reappraised and they're going to look at comps and you know, what improvements did you put in? But really, what do the appraisers look at? Net operating income. So this cap rate kind of gives an investor a starting point of like, okay, this is what, okay, let me see what I can do with this property. And then they're going to go into due diligence and look at the rent rolls and the lease agreements and all the expenses and the vendors and can I shave off some money with utilities or the garbage or the landscaping or whatever. All right, but then here's the real deal. You start to put debt on this, say, I don't have a million dollars in cash, Mark. Well, the cap rate doesn't change when you might have debt. The cap rate's independent of debt. You put debt in this, you might need negative cash flow. You might be positive cash flow. It's a different analysis. So when you say, well, that's my cap rate, even if I put down 20% and get a loan for 80%, dude, that's going to be a whole different analysis. So let's hit the whiteboard. Let's do it. So let's look at two situations. Let's say in this situation I put down 30% or 300 grand, and in this situation we're going to put down 50% or 500 grand. Now you may say, well, I'm going to do a seller carryback and I'm going to only put down 5% or 10%. Okay, fine, you can do the math. I just want to show you how the cash on cash ROI is going to be different than the cap rate. And then we can get into taxable income and even internal rate of return where you might have calculate in appreciation and mortgage reduction. So lots of ways for a real estate investor to look at a property. So here we have, we have our cap rate, remember of 7%. And now we're going to go get some debt. Now I was just looking at a property, North Salt Lake the other day, it was a little over $1 million. And I was talking to my broker, love him. I'll give Robert Farnsworth a shout out, great guy. And he said, mark, right now we can get commercial loans in the six to six and a half percent. He's going to, you know, probably six and a half this week, but blah, blah, blah. And I'm saying, okay, for our example we're going to go with six, which would be pretty sweet. He's like, you can get a loan for 700 grand because see, we're going to put 300,000 down and then that means I need bank loan. So I'm going to have a mortgage, if you will, of 700 grand. And so that mortgage is going to be at a 6% interest rate. And with a commercial deal in multi unit you're going to usually use a 15 year a.m. so we're going to do a 15 year amortization schedule, clean that up a little. And with the 15 year AM let me tell you what the payment is going to be. It is going to be very interesting here. Okay, so the payment is. Oh my gosh, you're going to love this. 70,008 84 and the interest on that is 41,192. That's the interest portion and the principal portion is 29,691. So there's my mortgage payment. So if we look at a cash on cash return or what is my cash flow? I've got 70. Remember our fact pattern, we have $70,000 of net income to cover our debt cost. Well, our debt is running a $70,000. So this property is a zero cash flow. Zero cash flow. And what's interesting is when you put interest into your ro into your net operating income. So I'm going to take this interest amount of 41,192 and subtract it from my net operating income, which brings me down to 28,808. My cap rate after debt. So it's cap rate after debt is now 2.8%. Now you might say, well Mark, I'm getting this cap rate of 7% on my cash. Yeah, you are. And the debt is only costing me 6%. So I'm making 1% on this interest payment. That's what it's costing me. And so there's, there's a variance there and that's good. If I can get a cap rate higher than the cost of debt, I'm making money on the money I borrowed and I'm making the 7% on my down payment. The problem is cash flow because there's a mortgage payment with principal and interest. So Even though the NOI ends up being $28,000, that's great. And I still have a positive cap rate, I'm actually zero cash flow. So that's how you can. And so for some of you, you're like, well I can't, I can't do that. That's not tolerable. Well then fine. But this is a type of analysis you'll do. Now let's look at 500 grand. Maybe you're rolling money over from a 1031. This could be in your retirement account. You might be using your IRA or your 401k to get the loan. And with 50% down, that's a non recourse loan. So you don't even have to co sign on this. Doesn't matter what your credit's like. Your 401k could buy this building with $500,000 down. Now this is a nice time to say a little side note. Later this month on the 25th, right? 25th guys. Okay, 25th of this month, May 25th, we're doing a virtual. It's our second annual virtual real estate tax summit. Full day on tax strategies just like this. Analyzing deals, cost segregation, 1031 exchanges, CRTs, real estate professional. What can I write off? What can I not write? Short term rental loopholes, long term rental strategies. We're covering it all in one day. Virtual. Totally helpful for any real estate investor and especially you real estate, your you tax professionals out there. It's $100 off through tonight on our early bird special. So $100 off the virtual ticket and it's already totally affordable. I need the purchase. What's the total price of the ticket guys? And then I'll get that for you. So make sure down below you get registered for the event even if you miss the early bird special. You saw this later. How much was the total price?

299. With the discount?

With the discount, yes. So it's normally 399. So 400 bucks for the day with the discount 299. So check that out down below. Okay, now let's get back to our whiteboard. So let's say I put down 500 grand. So now I've got my $1 million property, a $500,000 mortgage, and I'm going to have to put in my. Okay, I got my 500,000 down and $1,000,000 purchase price. Boy, I didn't get the order of this. Let's make this look prettier because I want, I want this to look just like the other side here. We got to make sure this looks pretty. All right, so if we go this route, we're going to take our $1 million, 500,000 down, $500,000 mortgage, and we're going to have this same interest rate, 15%, 15 year AM and I could do this with a retirement account even with no co signing. And what's my mortgage payment now? It gets interesting. The mortgage payment is now $51,000 because I'm putting down more money. My mortgage payment went down by about $19,000. So that's pretty cool. So if I take now and let's see, how much is interest? Interest this is 29,423. And principal is. Here we go. Yeah, and is 40,000. No, that's the principal and interest. Oh, I don't have my principal number here. Okay. But we know the interest is 29,000. So now if I look at my noi, this is pretty cool. 51,000. I'm sorry, my NOI is 70,000. So you can see how these numbers get tricky. So my noi, remember is 70,000. That's what I'm going to make after my direct expenses minus my interest expense, then that means I have 40,005. 77 of an adjusted NOI. So this is my net operating income after debt. So that changes my cap rate. So now my cap rate is 4%. It's $40,000 approximately divided by the 1 million. So I'm at a 4% cap rate. But the beauty of this is the cash flow because now if I take my net operating income 70 grand minus the cash flow. So this is cash in, is my rent or nano cash in noi after all the direct expenses. And I subtract out the mortgage payment of the $51,000. 51,000. That means I have $19,000 of cash flow. Okay. Now I'm not negative cash flow. And if I take that 19,000 and divide it by the cash I invested, not the purchase price, I'll tell You explain why in a moment. 19,000 divided by my down payment, that gives me 3.3.8% cash on cash. So if I take my money and put it in, let's say a money market account, I might get 4% or more. Or I can put it in this real estate deal, I'm going to make 3.8% just on the cash. Cash on cash. But I have a 4% cap rate overall even after my debt service. Oh, so this number of having a 4% cap rate and a 3.8% cash on cash looks really attractive because what am I going to do? I'm going to go back here and I'm going to try to increase rents, decrease expenses, increase my noi, which is going to drive up my cash on cash return and drive up my in my cap rate. Then if I can take this cash on cash, add to it appreciation and mortgage reduction and maybe I'm getting some tax benefits, maybe that depreciation is flowing through and it's saving me some taxes. We don't know. So when I start adding up all these other benefits, this gives me my total internal ROI rate, return on investment. My internal, after all the factors, and you might have others, everybody can build their own model internal return on investment. And so I know some investors that are like, this is the number I'm really looking at. What's my internal roi? I want to really know what I'm going to be making on this. And as long as it cash flows, I'm cool. I just don't want to be upside down. Cash flow and oh, the cap rate. Yeah, that helps me out because I know if I can drive up my cap rate before debt, then I can get a higher cap rate. I'm going to see a direct impact on the value. So that, my friends, is hopefully been extremely instructional. I hope it is. It can be a complicated topic, but I broke it down. Hopefully you can watch it again if you need to and really start saying, you know what, when I analyze a property, I am going to look at all these factors. I want to be able to look at cap rate, understand what that means. Cap rate after debt service, my cash flow based on the amount of cash I put in and the internal rate of return of everything combined. That's going to help you make better, more informed decisions as a real estate investor. Now I've got some spreadsheet I can send to you as well. It'll be down in the description. If you sign up for my newsletter, we'll send you that spreadsheet. And my ultimate, my 30 ultimate tax guide tips. 30 tips on how to save taxes. It's free. I have a weekly newsletter. I. I hope you can join us for the virtual Real Estate Tax Summit. We're going to save you so much frickin money and even talk about how do you again use that IRA or 401k to buy a real estate deal as well? People, the real wealth in this country comes from investing in real estate and I think it's just extremely powerful. Now maybe we can open it up for a couple of questions on the topic if you've got one. I don't want to jump off the topic. Is there anything don't stump me. This, this could be tough. What do we got?

Okay, what is the point to which the tax and depreciation values negate the losses on the property from gk?

Okay, so someone said well Mark, let's say, let's go over here. Let's say I'm negative cash flow or I'm break even cash flow. So let's go with the first model I put down 30% because I only had 300 grand and I'm just break even cash flow. I'm willing to take that risk. And someone said well if I'm getting great tax benefits, is that when does it negate the risk or the cost of zero cash flow? And it could be maybe a little bit of cash flow and a little bit of tax benefits or a lot of tax benefits and a little bit of cash flow. Okay people, now take me off here. This is so important. I got to look you in the eye people. I love saving taxes. I'm a tax guy. I love saving fricking taxes. But if you're buying properties for tax benefits and you really don't have a good quality cash flow that you is sustainable or a cap rate that you know you can push the needle with and maybe increasing rents or lowering expenses. When I see people let the tail wag the dog and let taxes drive a decision, it is. It never turns out. It does not turn out. Well now you might be doing a real estate deal that's going to give you some cost seg and a big depreciation write off. Sure you save some money this year in taxes. You may say oh well I'm going to save so much in taxes it makes up for that cash flow. Yeah, what about next year? What about the year after that? You got a cash flow. A property with terrible cash flow. Maybe you couldn't drive the needle when with increasing rents and lowering expenses and you're going back. Oh, I wish it was the first year when I got all those tax benefits and you're screwed, people. The tax benefits are the cherry on top and they can be a big part of the decision if you can make sure you've got your bases covered. Quality cash flow is killer, guys. I lived through the 2008 real estate crash. People that had negative cash flow properties lost them. People that were just break even with cash flow, they could take the hit with the equity drop that happened all over America. They're like, hey, at least I'm breaking even. Or better with cash flow, I can wait it out. And what happened six years later, they were back on top. The equity bounced back, but they could weather the storm because they had decent cash flow. Never ever sacrifice cash flow for a short time short term benefit. That's my opinion. All right, maybe one or two more questions.

Does direct cost include employee cost than paying yourself?

Oh, great question. Are they hearing you? Should I repeat it?

They should hear me.

They should hear you. That's Patrick, my studio manager. Appreciate you, Patrick, doing a great job. I'm going to repeat it anyway. He said, does the expenses you put on here, Mark, included paying yourself and what was the other one?

Employee cost and paying yourself employee costs?

Well, if you're doing a big multi unit and you're going to have property managers involved or employees is a unique word because this is going to be a large operation if you actually have a W2 situation. But let's go to the whiteboard. So we have our $1 million purchase price and let's. We're going to go with traditional cap rate. So you've got 100 grand rent and we said you have 30,000 in expenses and you net 70 grand. That's your NOI. You do your math, that equals a 7% cap rate, right? Okay, well Mark, where do I pay myself? Is that an expense? No, no, no, no, no. You paying yourself is down here because when you go shop the property, you don't want that in the expense line anyway. That's going to drive down your noi. Lower cap rate, less value. You want the highest value for when you go to resell this in one year, three years, five years. So you want to be working that noi to increase it as much as possible. If you do have employees. Yes, employees would be in here. And you're going to have property management in here. You're going to have utilities, you're going to have property taxes. You're going to have all the expenses directly related to the property employees is an odd one. I mean, you're going to have one hell of an apartment building with employees and a commercial building with employees on salary, sure, fine. But typically it's going to be an outside property management situation where they're taking anywhere between 5 to 8 to 10% of the gross rents, which will be an expense on that line. All right, one last question. Oh, no more on that. Okay, we're good. We're going to wrap it up. We're on a tight schedule day and I just want to tell all of you, keep buying real estate. Real estate. That's what the wealthy people do. That's what I'm trying to do. I want to be wealthy. And I love analyzing deals. Make sure you can explain the cap rate to your family, your best friend, your significant other, your kids. Practice it. Use these examples. Have you say, tell someone, hey, do you want to know what cap rate is? You try to explain it. It took me a couple of times, let me break that down. Throw some debt on it, then do the cash flow. You can get an amortization schedule, easy schmeezy on Google. Start running different down payments. And if you'd like a spreadsheet on how to analyze a real estate deal down below, there'll be a link to get that spreadsheet or instructions on how to email to get that will be free. Want to help you do your investments and everyone, thank you for being here. See you next week.