Capitalization rate: How to use cap rate in your real estate investing

The good folks over at Property Metrics wrote this very helpful blog post about capitalization rates in real estate investing. The post explains what cap rate is, how to calculate it, when investors should use it, as well as some alternatives that some investors use.

In my opinion, cap rate is one of the key metrics that real estate investors need to know about their properties — current properties as well as potential deals. Investors should memorize the simple calculation to determine cap rate so they can calculate it quickly (annual net operating income/cost of deal)

Admittedly, cap rate is a back-of-the-napkin type of of calculation and there are other factors that have the potential to impact the cap rate (such as a regular increase in annual net operating income or growing costs to maintain the property, etc.) But overall, this is a very servicable calculation.

There are three reasons why I really like the cap rate.

CAP RATES EXPRESS THE OPPORTUNITY (OR COST) OF RISK

I’ve been writing a lot about risk and risk management lately as I interact with Aswatch Damodaran’s excellent book Strategic Risk Taking. Cap rate fits right into the conversation of risk management because cap rates help you quantify the reward you get for the risk you take in real estate investing.

Many potential real estate investors scratch their head in wonder at how to determine whether or not a deal is worth doing. The cap rate, in spite of its flaws, helps to illuminate the answer. Investors can compare the cap rate of the real estate deal against the returns they can expect to get from other investments. In the article by Property Metrics, they give the example of someone who has $10 million to invest and they can invest their money in a property with a 5% cap rate or a 3 month T-Bill with a 3% yield (and is often called “the risk-free rate”). The difference between the two is 2%. That’s the return you get for the additional risk you’re taking over and above a T-Bill.

It doesn’t matter how much money you have to invest, the comparison is the same: Look at the amount of money you have to invest and compare your real estate investment options it to a T-Bill. The difference is the return percentage you hope to earn for the additional risk you’re taking on.

CAP RATES ENABLE YOU TO COMPARE ALL DEALS

When you are trying to decide if a deal is worth doing, or if you are trying to choose one deal from several potential deals, the cap rate can help you here as well. Cap rates reduce all of your deals down to one easy-to-compare number. So if you are looking at a commercial property or a bungalow or an apartment complex (which are 3 very different real estate investments), you can still easily compare them. Obviously this isn’t the only piece of information you’ll use to determine whether or not you want to do a deal but it’s a helpful piece of information.

CAP RATES HELP TO KEEP YOU ON TRACK

As the article indicates, cap rates viewed over a period of time can reveal trends. When you view cap rates for a particular market, you gain a glimpse of how that market is doing. When you view cap rates for your own deals, factoring in additional costs or changing values, you can determine how your own deals are doing. You can do this for individual properties, and you can do this for your entire portfolio of properties as well, gaining an aggregate view of the trend of your portfolio.

So get to know cap rates. Make them one of the numbers you pay attention to in your business and practice calculating cap rates so you can build up some confidence in understanding the numbers and using them.

100 proposals in 100 days — Update

Last week I started a new personal challenge — to write 100 proposals in 100 days. I wanted to give you an update now that I’ve just passed the one-week mark of the challenge.

Here’s the blurry chart I made to track my progress.

aaron-hoos-writer-100-proposals-tracking

It started well on Thursday, June 27th. I threw myself a softball to start: My first proposal was actually to a client. (If you remember the rules to my challenge, I am allowed to pitch to existing clients but it has to be for new work). The proposal was for a project that I thought would be a great fit for her business based on some of her business goals that we talked about in the past. To my great joy, she responded the same day with a positive response so we’re starting that project next week!

One of the reasons that I went so easy on myself on Day 1 was because I had guests visiting from out of town. They were here from Friday through Monday. It was so good to see them (haven’t seen them for at least 12 years)! Because I knew I was going to be busy with them, I spent Thursday and part of Friday planning the other proposals that I’d send out over the weekend so that I could do it quickly each day. I told my friends about my challenge and they generously let me slip away each day for a few minutes to write and send the pre-planned proposal for the day. So day 2, 3, 4, and 5 passed without incident.

After they left on Monday, I kept going. Day 6 was Tuesday. I just finished day 7 yesterday.

aaron-hoos-writer-100-proposals-tracking-day7

Since day 1, I’ve sent proposals to three prospects who I’ve never worked with before, a joint venture partner, a referral who might be a good fit for some really interesting work, and a magazine. Along with the positive response from my very first proposal, I’ve received another “let’s get started!” approval and I’m in the hammering-out-the-details phase with a third.

That second “let’s get started” has already started! I’m well into the work for that new client already!

Today is day 8 and I’m well on my way to completing a proposal for today.

That’s the good news.

Here’s the bad news: This is hard. I absolutely love writing these proposals. But they have been taking up more time than I thought they would. Writing and sending them is easy, actually. The harder part is thinking about who to pitch to. What worries me is that so far I’ve been sending these to (mostly) people with whom I already have their contact info and have been thinking about a project already. But a couple have been brand new (in the sense of: I didn’t know who I was going to pitch to when I sat down to write the proposal) and those took a considerable amount of effort… and the number of “brand new” contacts is going to grow very shortly once I run out of contacts whose projects I’ve been thinking of proposing already.

I’m not going to let it get me down. This blog post serves two purposes — to update you about my progress on this personal challenge, and also as a bit of a “checkpoint” for me to think about how I can improve the process. I’m enjoying it but I don’t want it to happen at the expense of anything else (like client work). I need to do more planning and even to start thinking about proposals a few days prior to when I want to send them.

But with 2 approvals of 7 proposals so far, I’ve got some really cool work starting up in the near future.

Risk as a source of profit

I’m reading Aswath Damodaran’s book Strategic Risk Taking: A Framework for Risk Management and I’ve been blogging about it from time to time as I chew through the concepts.

In chapter 4 of his book, Damodaran talks about how, in the nineteenth century, the idea of risk changed. Risk was once thought of as a function of loss (which is why we have insurance) but then it changed and risk became a source of profit (which prompted investors to create various statistical risk measures).

The idea of risk as a source of profit has been a rock in my shoe. I can’t get the thought out of my head.

A FEW WAYS THAT BUSINESSES PROFIT FROM RISK

It strikes me that all business profit from risk in many different ways:

First, businesses profit from risk by buying raw materials at a low price and then selling finished products at a higher price. They risk raw material prices going up and they risk that their finished products will have pricing pressure to cost less. They minimize this risk by negotiating for lower raw material costs and by periodically raising the prices of finished products.

Second, businesses profit from risk by hoping that people need their products and services. Here’s an example: People used to get where they needed to go by foot or by horse. Ford (and others) took the risk that people would want to get somewhere faster and a little more comfortably so they built a car. Here’s another example: Businesses could probably hire people to perform various functions and tasks but software companies took the risk that those same functions and tasks could be automated to free up staff for other purposes. Here’s another example: People could always make their own food but McDonalds took the risk that sometimes people would not want to cook but they would want something fast and affordable that they can eat on the go. Businesses minimize this risk by doing market research first and by making mid-course adjustments based on customers feedback.

Third, businesses profit from risk by competing with other businesses. They bring a slightly different business to market and hope that their offering is more attractive to customers than their competitors’ offerings (and they hope that another competitor doesn’t come along and out-do them). Businesses minimize these risks by targeting a narrow market, providing a ton of value, and marketing like crazy.

Fourth, businesses profit from risk by hiring staff to do the work that will collectively result in a product or service being delivered. The risk is that they’ll find enough employees to hire affordably, and that even on unproductive days, those employees will still collectively do enough work to deliver what the business promised. Businesses minimize these risk with hiring practices, training, incentives and perks, human resources departments, employee reviews, and more.

Fifth, businesses do all of this in an environment that risks running unprofitably because of inflation or litigation or government regulations (and more). Businesses minimize these risks with investing and expansion, lobbying, insurance, and more.

As I write this, I realize I could go on and on. There are many of ways that businesses accept risk to earn a profit.

WHAT ABOUT FOR YOUR BUSINESS?

If you run a business, you accept the risks in order to earn a profit. Ultimately, you are risking the possibility that people will try to do something themselves instead of getting you to do it for them.

And if you think “They couldn’t do this themselves”, you’re kidding yourself — which is exactly why financial advisors and real estate professionals are facing industry-changing competition from DIY options.

Every consumer has a do-it-yourself option for everything in their life (from health to food to finances to legal to transportation to employment — you name it!). Your job as a business owner or professional is to “take on the risk” and make your product or service so awesome that the customer immediately sees that their DIY option as the riskier (costlier and more time consuming and failure-fraught) choice.

Reaching toward the horizon: How business acquisition is a lot like Mars exploration

It’s funny when you read different things but they all seem to be connected in some way. That’s happening to me right now and this blog post is my attempt to put some of those ideas in order.

I’m reading a book called Strategic Risk Taking (by Aswath Damodaran), which is a book about risk taking in business and the markets; I’m reading a book called Sex on the Moon (by Ben Mezrich) which is a mostly-non-fiction account of a guy who stole lunar moon rocks; the latest issue of National Geographic arrived at our house the other day and it includes an article about Mars exploration; and then a friend posted on Facebook the other day about the Golden Record, a message from earth to aliens that was sent out on the Voyager spacecraft; I’ve also been reading a bit about the applications for a one-way pioneering trip to Mars.

All of those readings ended up being connected (at least in my mind) and related to humanity’s desire to push beyond the boundaries we’ve set for ourselves — to accept the costs and the risks associated with the unknown and to pursue expansion.

I was particularly struck by the Mars exploration missions themselves. Starting back in 1960, humans have been reaching for Mars. In those early years, and in spite of staggeringly high costs, most of the missions failed. Here’s a helpful list on Wikipedia of Mars missions that have succeeded, partially succeeded, and failed. (You’ll note that this list combines all international attempts so when I say “we” in this blog post, I’m referring to humanity in general).

You’ll see when you look at the chart that we started making attempts in 1960 but the first 6 attempts in the first 4 years failed. On the 7th try, we had something called success but the multi-million-dollar mission was considered a success even though it only sent back 21 photos of Mars.

PIA16239_High-Resolution_Self-Portrait_by_Curiosity_Rover_Arm_CameraIt wasn’t until 1969 that we started to achieve success beyond a couple of photos and even those missions weren’t anything other than flybys; it wasn’t until 1971 that we had our first orbital mission success; it wasn’t until 1976 that we actually got a lander to touch down on Mars and start sending information back. (There were a couple of sketchy lander attempts earlier that didn’t send back data).

Even after this first successful attempt, there have been many other attempts with mixed results — success, partial success, and failure — pretty consistently over the years; beginning in 2000, we started achieving more regular success; today the thought of sending a team to Mars (at least one-way) seems more and more likely, with initiatives like Mars One hoping to achieve it within a decade.

When you read my timeline synopsis above, you notice some interesting things: We started exploring Mars in 1960 and spent (collectively) billions of dollars to do it, facing failure after failure until the first hint of success coming in 1964 and the first real success coming in 1969 — a full nine years after those first failed attempts. And results continued to be mixed right up through the 1990’s. Now, our successes are more frequent but they are still short-lived, costly, and the track record isn’t perfect.

But we’re doing it anyway. We’re pushing forward anyway. In spite of the costs and the risk, we explore with an eye on knowledge and an eye on expansion. This isn’t any different from when Columbus (and his peers) pushed forward and sailed into the unknown seas in spite of dire warnings like “There Be Dragons”.

Okay, you’ve patiently read through 550+ words about exploration. So what does this have to do with business?

At the risk of getting a little philosophical, businesses have a similar need to push forward. They explore and expand in an attempt to grow. Although most business’ purposes are profit-driven (as opposed to humanity’s quest for knowledge and bragging rights), the outcome is the same: Businesses have an inherent need to grow beyond themselves. So we shouldn’t be surprised when we read in The Economist that mergers and acquisitions are picking up.

And then I read this article that ponders Why we keep coming back for mergers even though they don’t work. The article was interesting because it really did highlight the constant, costly failures that businesses have experienced in their merger attempts. But businesses keep doing it anyway. Why?

I think the answer lies in our discussion above about Mars exploration. We do it anyways because we need to. The costs and risks are high and the rewards are often mixed even when there is success, but businesses need to grow beyond themselves.

Unfortunately, the options businesses have to grow are limited: They could start something (i.e. on a small scale, like an innovative product, or on a larger scale, like starting a new brand or business) or they could buy something that is already running. The possibility of crash landing is always there but businesses do it anyway because they hope to get to the point when they learn how to do it right. It’s easy to point to mergers as being frequent failures because they are more public and we don’t always see the many failures in a company’s skunkworks.

We often praise Edison for his perseverance while building an (anecdotal) 10,000 failed attempts at a light bulb but we readily criticize a business that tries to merge and fails.

Businesses need to grow, and mergers and acquisitions are an option (even though they are rife with failure). But we need to do it anyway for the very same reasons that humans are exploring Mars. The costs and risks are high and success is elusive… but we get better each time. And maybe — just maybe — a business will find the formula it needs to make it work.

(Image courtesy of NASA/JPL-Caltech)

What I’m working on this week (July 1 – 5)

Had a great weekend visiting with friends who we haven’t seen in nearly 15 years. (We’re friends on Facebook but we haven’t seen them in person for a decade and a half). Good times; saying goodbye to them this morning as they return home.

This is an interesting week to work: It’s Canada Day today (so it’s technically a day off for most Canadians) but because most of my clients are American, things tend to quiet down on US holidays… and July 4th is coming up shortly.

Happy National Celebration Day to my Canadian and American friends this week! :)

Here’s what I’m working on this week:

  • I’m working on a book for a mortgage broker.
  • I’m putting the finishing touches on an ebook (which is part of a joint venture I’m doing with someone else… I’ll post about that when it goes live).
  • I’m starting on a book (or maybe an ebook?), which is a joint venture between a real estate investor and I.
  • It’s the beginning of the month so I have a bit of administration work and invoicing to do from last month.
  • My Sales Funnel Bible book is kind of stalled in the editing process right now. I hate it when that happens so I’m mentioning it here to embarrass myself to work on it again. I think the problem is: I’m just doing a spelling and grammar edit on the book but I’ve got a lot of other things cooking right now that the book gets deprioritized every day. Grrrr!
  • And, of course, I’m pushing forward on my 100 proposals in 100 days challenge. I’ll give you an update on that a little later in the week.