🧑‍🎄🎄 The 2nd day of Christmas

Yesterday we broke down underwriting made simple.

Today we are diving into a term you will hear constantly in commercial real estate: cap rate.

Most people toss this word around like everyone knows what they mean. But before you nod along, you need one key question in your pocket.

What cap rate are we talking about?

Because there are two. And they are related, but they are not the same thing.

1. The market cap rate

This determines the market value of a property. Take the net operating income and divide it by the market cap rate. If a market is trading at a 6 percent cap, that number tells you what a buyer will probably pay.

2. The operational cap rate

This is the cap rate based on how the property is actually performing. It measures what the property is spitting off right now compared to your all in cost.

Brokers often quote this without telling you which one they mean.

Let me show you with real numbers from one of our early deals.

We bought a property for 750K.

After closing costs, reno, and carry, we were all in for about 1.055 million.

At purchase, the NOI was 51K.

That gave us an operational cap rate of 4.83 percent.

The market cap rate was 6 percent.

On paper it looked like we overpaid.

But we knew the market income was much higher than what the seller was getting.

We budgeted 250K of renovations and pushed rents over 15 months.

The NOI jumped to 90K.

Now run the numbers again.

A 90K NOI with our same all in cost put our operational cap rate at 8.53 percent.

The market was still trading at 6 percent, so the valuation supported a refinance at about 1.5 million.

The bank handed us a loan that returned all of our money, paid back investors, and set the property up to cash flow.

That is the power of knowing the difference between operational cap rate and market cap rate. They tell two different stories. Great investors know how to read both.

So as you analyze deals this season, slow down when someone throws out a cap rate.

Ask the follow up. Which one?

Day two of the 12 Days of Real Estate Christmas is in the books. See you tomorrow for day three.