This excerpt from our new webinar series discusses commonly used metrics.
Note: The following is a brief excerpt from the first episode of Real Estate Investing 101, PeerRealty’s new free on-demand webinar series. In this first episode, PeerRealty Head of Investment Jeff Rothbart discusses the financial analysis of real estate transactions and explains some commonly used metrics.
Hi, my name is Jeff Rothbart, and I’m the Head of Investments for PeerRealty. We are a Chicago-based real estate crowdfunding platform. Today, we are going to talk about some of the basics of real estate investing. We want to give you some of the basic terminologies that investors go into in deciding whether or not they want to invest in real estate.
The first concept that I want to discuss is Net Operating Income. Like most businesses, commercial real estate is a business. We have revenue, we have expenses. Gross revenue net of those expenses is what we call Net Operating Income, or NOI. NOI is the basic measure by which we look at a real estate deal. Real estate is traditionally valued by taking your ROI [return on investment] and applying cap rate to it. For those of you who are familiar with businesses or stocks, if you are familiar with the concept of P/E ratios or profits to earnings ratios, cap rates are basically the inverse. They are earnings to price ratio. And so, the cap rates are measured of valuation of real estate as well as an indicator of risk in a real estate transaction.
By the way, I have an example: if we have a property that had an NOI of $100,000 and a price of $1 million, that would be a 10% capitalization rate. The basic law of cap rates is that when the price goes up, cap rate goes down and when cap rate goes down, the price goes up. So, for example, when we have $100,000 of income and a $1 million price we have a 10% capitalization rate. When we have, say, $100,000 of income applied to a $1.2 million valuation that is equal to an 8.33% capitalization rate. So the price went up, and cap rate went down. Conversely, when the price goes down from $1 million to $800,000, the cap rate goes up to 12.5%. From a purchasing standpoint, the higher the cap rate the better.
Now, that being said, higher cap rates also indicate higher risk in the transaction. Cap rates vary from time to time and they vary based on the risk of the transaction, but there are a few primary factors that correlate with cap rates versus interest rates. As interest rates rise, cap rate in theory rises as well.
The second is market efficiency and market conditions. If we experience market downturns similar to what we did in 2008, then cap rates in theory rise. In a rising economy similar to what we have been in for the last 12-18 months, cap rates will compress and come down.
[Other factors include] property conditions: older properties have a higher cap rate than newer properties with a lower cap rate. The creditworthiness of the tenant: an AAA rated tenant will have a lower cap rate than a bankrupt tenant, right? There is more risk with a bankrupt tenant or a less creditworthy tenant then there is with the US government or some other investment grade tenancy. And then lengths of leases: real estate is secure or not secure based on the duration of the lease or leases. The shorter the duration of the leases and the more risk that is associated with the transactions, the more potential costs and therefore, you must have a higher cap rate in a transaction like that.