WEBVTT 00:00:00.000 --> 00:00:02.180 Welcome back to the Deep Dive. I want to start 00:00:02.180 --> 00:00:06.240 today with a scenario that used to drive me absolutely 00:00:06.240 --> 00:00:08.619 crazy. Okay, I'm listening. You're scrolling 00:00:08.619 --> 00:00:10.779 through real estate listings on a Saturday morning, 00:00:10.939 --> 00:00:14.140 because that's what we do for fun now, and you 00:00:14.140 --> 00:00:17.719 see this rundown duplex in the middle of nowhere. 00:00:18.369 --> 00:00:21.190 Yeah. Let's say it's listed for $100 ,000. Okay. 00:00:21.230 --> 00:00:23.390 I can picture it. Peeling paint, maybe a chain 00:00:23.390 --> 00:00:26.030 link fence. Exactly. And then you switch tabs 00:00:26.030 --> 00:00:29.050 to some high -end commercial listing site and 00:00:29.050 --> 00:00:31.690 you see a single parking spot. And I mean literally 00:00:31.690 --> 00:00:35.009 just a slab of concrete with painted lines in 00:00:35.009 --> 00:00:37.329 downtown Manhattan or maybe Hong Kong. Right. 00:00:37.429 --> 00:00:40.409 And it is listed for the exact same price, $100 00:00:40.409 --> 00:00:42.829 ,000. It happens more often than you'd think, 00:00:42.969 --> 00:00:46.880 especially in dense cities. It does. As a normal 00:00:46.880 --> 00:00:48.759 person, you look at that and you think, OK, the 00:00:48.759 --> 00:00:50.520 price tag is the same, so they must be worth 00:00:50.520 --> 00:00:53.159 the same. Just simple logic. But then you talk 00:00:53.159 --> 00:00:55.359 to a professional investor and they almost laugh 00:00:55.359 --> 00:00:57.539 at you. They tell you the parking spot is a safe 00:00:57.539 --> 00:01:01.380 haven and the duplex is a money pit. Or depending 00:01:01.380 --> 00:01:02.759 on the year, maybe it's the other way around. 00:01:02.859 --> 00:01:05.640 The point is they're seeing a layer of data that 00:01:05.640 --> 00:01:08.099 is completely invisible to the price tag. They 00:01:08.099 --> 00:01:09.459 aren't looking at the price. They're looking 00:01:09.459 --> 00:01:12.620 at the engine inside the price. Exactly. And 00:01:12.620 --> 00:01:15.090 that engine. is what we are going to take apart 00:01:15.090 --> 00:01:18.790 today we are tackling the capitalization rate 00:01:18.790 --> 00:01:21.469 or as everyone calls it the cap rate the infamous 00:01:21.469 --> 00:01:23.689 cap rate and i'll be honest when i first saw 00:01:23.689 --> 00:01:25.629 this topic in our research stack i wanted to 00:01:25.629 --> 00:01:28.950 run it sounds like the driest most boring piece 00:01:28.950 --> 00:01:31.390 of financial jargon imaginable it sounds like 00:01:31.390 --> 00:01:33.530 homework it really does it sounds like something 00:01:33.530 --> 00:01:35.230 you learn in an accounting class you're trying 00:01:35.230 --> 00:01:38.150 to sleep through but as i went through the cbre 00:01:38.150 --> 00:01:40.530 data the inquiry i have historicals and the case 00:01:40.530 --> 00:01:42.930 studies we have for this deep dive especially 00:01:42.930 --> 00:01:46.030 that Stuyvesant Town disaster in New York, I 00:01:46.030 --> 00:01:48.510 realized I was completely wrong. It grabs you 00:01:48.510 --> 00:01:51.469 once you get into it. It does. The cap rate isn't 00:01:51.469 --> 00:01:54.689 just math. It's a universal translator. It's 00:01:54.689 --> 00:01:57.390 the only tool that lets you compare that Ohio 00:01:57.390 --> 00:02:00.750 duplex to a Manhattan skyscraper and actually 00:02:00.750 --> 00:02:02.849 understand which one is the better bet. That 00:02:02.849 --> 00:02:04.890 is the perfect way to frame it. Think of the 00:02:04.890 --> 00:02:07.459 cap rate as a thermometer. If you walk up to 00:02:07.459 --> 00:02:09.419 a building, the price tag tells you the size 00:02:09.419 --> 00:02:11.219 of the building. Maybe it's grandeur. Right. 00:02:11.300 --> 00:02:13.280 It's physical presence. But the cap rate tells 00:02:13.280 --> 00:02:14.759 you the temperature of the market surrounding 00:02:14.759 --> 00:02:18.159 it. Is it overheating? Is it freezing cold? Is 00:02:18.159 --> 00:02:21.180 it a risky bet that might burn you or a safe 00:02:21.180 --> 00:02:23.560 bet that will take, you know, 30 years to pay 00:02:23.560 --> 00:02:26.159 off? It's a vital sign. So our mission today 00:02:26.159 --> 00:02:28.719 is to give you, the listener, that thermometer. 00:02:29.159 --> 00:02:31.479 We're going to move beyond the basic arithmetic. 00:02:32.060 --> 00:02:34.599 though we will absolutely do the math, and look 00:02:34.599 --> 00:02:37.419 at the story this number tells about risk, about 00:02:37.419 --> 00:02:40.159 market psychology, and about the future. We're 00:02:40.159 --> 00:02:41.740 going to look at the math, but we're mostly going 00:02:41.740 --> 00:02:44.259 to look at the psychology behind the math, because 00:02:44.259 --> 00:02:46.659 ultimately real estate value is just a collection 00:02:46.659 --> 00:02:49.240 of human expectations about what the future holds. 00:02:49.479 --> 00:02:52.039 I love that. Okay, so let's start at the very 00:02:52.039 --> 00:02:55.979 beginning. Section one, the core mechanism. If 00:02:55.979 --> 00:02:58.659 I'm at a cocktail party and I want to sound smart, 00:02:58.900 --> 00:03:02.150 how do I define a cap rate? Without boring everyone 00:03:02.150 --> 00:03:04.789 to death. At its most basic, most fundamental 00:03:04.789 --> 00:03:07.569 definition, the capitalization rate is a ratio. 00:03:08.009 --> 00:03:10.750 Okay, a ratio of what to what? It is the ratio 00:03:10.750 --> 00:03:13.229 between the annual rental income produced by 00:03:13.229 --> 00:03:15.969 a real estate asset and its current market value. 00:03:16.210 --> 00:03:19.990 So income divided by value. Precisely. The formula, 00:03:20.189 --> 00:03:22.330 if you want to write it on a napkin, is capitalization 00:03:22.330 --> 00:03:25.150 rate and annual net operating income current 00:03:25.150 --> 00:03:27.370 value. Okay, and we're going to spend a lot of 00:03:27.370 --> 00:03:30.199 time on that net operating income part. Because 00:03:30.199 --> 00:03:32.759 it's tricky. Oh, it's a minefield. But before 00:03:32.759 --> 00:03:34.639 we do, I need a simple example, a back of the 00:03:34.639 --> 00:03:36.340 napkin example. Let's say I'm buying a building. 00:03:36.729 --> 00:03:38.509 Let's stick to the primary example from our source 00:03:38.509 --> 00:03:41.509 material. The math is very clean. Imagine a building 00:03:41.509 --> 00:03:44.270 is purchased for a sale price of exactly $1 million. 00:03:44.689 --> 00:03:46.490 Okay, I've got a million -dollar building. And 00:03:46.490 --> 00:03:49.569 let's say that building produces $100 ,000 in 00:03:49.569 --> 00:03:52.629 positive net operating income, or NOI, in a single 00:03:52.629 --> 00:03:55.069 year. Okay, so $100 ,000 in income. To get the 00:03:55.069 --> 00:03:57.509 cap rate, you take that $100 ,000 of income and 00:03:57.509 --> 00:04:00.729 you divide it by the $1 million cost. $100 ,000 00:04:00.729 --> 00:04:05.860 divided by a million. That's .10. So 10%. Correct. 00:04:05.979 --> 00:04:10.259 The capitalization rate is 10%. Which means what 00:04:10.259 --> 00:04:12.520 exactly? Does that mean I made a 10 % profit 00:04:12.520 --> 00:04:15.139 on my money? In a way, yes. It means that in 00:04:15.139 --> 00:04:18.160 a single year, one -tenth of the building's total 00:04:18.160 --> 00:04:20.899 cost is paid for by the net proceeds it generates. 00:04:21.300 --> 00:04:23.699 It's a yield. If you put that million dollars 00:04:23.699 --> 00:04:25.759 into a high -yield savings account, the interest 00:04:25.759 --> 00:04:28.240 rate would be your yield. I see. In a building, 00:04:28.459 --> 00:04:30.600 the cap rate is your yield assuming, and this 00:04:30.600 --> 00:04:32.560 is a big assumption for now, that you paid all 00:04:32.560 --> 00:04:34.480 cash. Okay, so it's like the building's annual 00:04:34.480 --> 00:04:37.100 dividend. That brings up this concept from the 00:04:37.100 --> 00:04:39.839 sources of the payback period, right? Yeah. Because 00:04:39.839 --> 00:04:41.699 if I'm getting 10 % of my money back every year, 00:04:41.980 --> 00:04:43.980 simple math says it takes me 10 years to get 00:04:43.980 --> 00:04:46.540 my million bucks back. Exactly. Capitalization 00:04:46.540 --> 00:04:49.000 rates are an indirect measure of how fast an 00:04:49.000 --> 00:04:51.509 investment pays for itself. At a 10 % cap rate, 00:04:51.610 --> 00:04:54.189 the payback period is 10 years. One divided by 00:04:54.189 --> 00:04:58.050 0 .10. Now let's flip it. Imagine a different 00:04:58.050 --> 00:05:00.829 scenario. Same million -dollar building. Looks 00:05:00.829 --> 00:05:03.529 identical from the outside. But the cap rate 00:05:03.529 --> 00:05:06.810 is 5%. So wait, for it to be 5%, that means the 00:05:06.810 --> 00:05:09.990 income must be lower. Same million -dollar price 00:05:09.990 --> 00:05:13.110 tag, but now it only makes $50 ,000 a year in 00:05:13.110 --> 00:05:15.889 NOI. Right. $50 ,000 divided by a million is 00:05:15.889 --> 00:05:19.250 5%. Now what's your payback period? Well, one... 00:05:19.449 --> 00:05:24.250 Divided by 0 .05. That's 20. 20 years. 20 years. 00:05:24.649 --> 00:05:26.689 So here is where it gets really interesting. 00:05:26.850 --> 00:05:28.930 And this is the part that is so counterintuitive 00:05:28.930 --> 00:05:31.430 for beginners. Right. If you see a building with 00:05:31.430 --> 00:05:34.089 a 10 % cap rate and another one with a 5 % cap 00:05:34.089 --> 00:05:36.170 rate, your gut instinct, your immediate reaction 00:05:36.170 --> 00:05:38.709 is to say. Wow, 10 % is way better. I get my 00:05:38.709 --> 00:05:41.250 money back faster. Double the return. Of course. 00:05:41.709 --> 00:05:43.930 Yeah, obviously. Who wants to wait 20 years to 00:05:43.930 --> 00:05:45.430 recoup their investment when they can wait 10? 00:05:45.589 --> 00:05:48.170 In almost any other part of life, faster and 00:05:48.170 --> 00:05:49.990 higher returns are better. But in the world of 00:05:49.990 --> 00:05:51.790 professional real estate, a lower percentage 00:05:51.790 --> 00:05:55.009 often, not always, but often signals higher quality. 00:05:55.189 --> 00:05:57.750 Wait, unpack that for me. How can a lower return 00:05:57.750 --> 00:06:00.810 possibly mean higher quality? It just feels wrong. 00:06:00.970 --> 00:06:02.949 Think about it from the perspective of risk. 00:06:03.629 --> 00:06:07.089 Why would any rational investor accept a 5 % 00:06:07.089 --> 00:06:09.930 return and agree to wait 20 years to get their 00:06:09.930 --> 00:06:12.509 money back? What has to be true for that to be 00:06:12.509 --> 00:06:14.610 an attractive deal? Well, they wouldn't unless. 00:06:15.170 --> 00:06:17.529 Yeah. Unless they were incredibly sure they were 00:06:17.529 --> 00:06:19.230 actually going to get that money. Right. Like 00:06:19.230 --> 00:06:22.769 rock solid sure. Exactly. They accept a lower 00:06:22.769 --> 00:06:24.649 return because they believe that income stream 00:06:24.649 --> 00:06:27.509 is incredibly safe and reliable. Or, and this 00:06:27.509 --> 00:06:29.629 is another piece of it, they believe the value 00:06:29.629 --> 00:06:31.970 of the building itself is going to skyrocket 00:06:31.970 --> 00:06:34.089 in the future. So they're paying a premium for 00:06:34.089 --> 00:06:37.050 safety or for growth? Precisely. They are willing 00:06:37.050 --> 00:06:39.389 to pay more money today for that stream of income, 00:06:39.449 --> 00:06:42.589 which pushes the cap rate down. Conversely, if 00:06:42.589 --> 00:06:45.220 a building is offering you a 10 % cap rate, or 00:06:45.220 --> 00:06:47.620 a 12 % cap rate. It's probably risky. It's the 00:06:47.620 --> 00:06:49.779 old, if it sounds too good to be true, it probably 00:06:49.779 --> 00:06:52.879 is rule. That's the first question a pro asks. 00:06:53.139 --> 00:06:55.759 What's the catch? Maybe the tenants are on shaky 00:06:55.759 --> 00:06:58.120 ground and might leave next month. Maybe the 00:06:58.120 --> 00:07:00.500 roof is about to cave in and needs a $100 ,000 00:07:00.500 --> 00:07:02.959 repair. Maybe the whole neighborhood is declining. 00:07:03.240 --> 00:07:06.980 The market is forcing the seller to offer a high 00:07:06.980 --> 00:07:09.870 -yield... a sweetener, if you will, to attract 00:07:09.870 --> 00:07:13.250 a buyer to take on that mess. So a high cap rate 00:07:13.250 --> 00:07:16.250 often means cheap building, high risk, while 00:07:16.250 --> 00:07:18.490 a low cap rate often means expensive building, 00:07:18.709 --> 00:07:20.889 low risk. That is such a crucial distinction. 00:07:21.129 --> 00:07:23.990 The cap rate isn't just what you get. It's what 00:07:23.990 --> 00:07:26.089 the market demands you get to convince you to 00:07:26.089 --> 00:07:28.790 take on the associated risk. Yes, it is the price 00:07:28.790 --> 00:07:31.490 of risk quantified as a percentage. OK, that's 00:07:31.490 --> 00:07:33.810 a huge piece of the puzzle. But before we get 00:07:33.810 --> 00:07:35.970 too deep into the psychology of risk and growth. 00:07:36.360 --> 00:07:38.759 We have to talk about the inputs. We keep saying 00:07:38.759 --> 00:07:42.240 net operating income or NOI. And I feel like 00:07:42.240 --> 00:07:44.279 there's a giant trap here. There is. Because 00:07:44.279 --> 00:07:47.540 income can mean so many things. If I ask my accountant 00:07:47.540 --> 00:07:49.680 what my income is, he gives me one number. If 00:07:49.680 --> 00:07:51.680 I ask the IRS, they give me a totally different 00:07:51.680 --> 00:07:54.360 number. This is the single biggest mistake people 00:07:54.360 --> 00:07:56.220 make when they first try to value real estate. 00:07:56.519 --> 00:07:59.959 We are in section two now. defining income correctly 00:07:59.959 --> 00:08:02.860 that numerator in the fraction the top number 00:08:02.860 --> 00:08:05.339 is net operating income it is not just profit 00:08:05.339 --> 00:08:08.560 in the loose sense and it is absolutely not cash 00:08:08.560 --> 00:08:11.519 flow okay so let's distinguish those for me what 00:08:11.519 --> 00:08:14.500 actually goes into calculating noi step by step 00:08:14.500 --> 00:08:17.439 you start with gross lease income that's all 00:08:17.439 --> 00:08:20.160 the rent checks you collect plus any other income 00:08:20.160 --> 00:08:22.560 like from laundry machines or parking fees the 00:08:22.560 --> 00:08:24.139 total amount of money that comes in the door 00:08:24.139 --> 00:08:27.829 right Then from that, you subtract the fixed 00:08:27.829 --> 00:08:30.189 and variable operating costs, the things you 00:08:30.189 --> 00:08:32.110 have to pay for to keep the building running. 00:08:32.309 --> 00:08:35.570 So property taxes. Yes. Even though you hate 00:08:35.570 --> 00:08:38.149 paying them, they are a direct cost of operating 00:08:38.149 --> 00:08:40.429 the business. They come out. Insurance. Yes, 00:08:40.490 --> 00:08:42.450 property insurance. That comes out too. What 00:08:42.450 --> 00:08:46.570 about fixing the toilet that broke in Unit 3 00:08:46.570 --> 00:08:49.970 at 2 a .m. on a Sunday? Absolutely. repairs and 00:08:49.970 --> 00:08:52.529 maintenance you also subtract landscaping snow 00:08:52.529 --> 00:08:55.350 removal any utilities the landlord is responsible 00:08:55.350 --> 00:08:57.629 for property management fees if you hire someone 00:08:57.629 --> 00:09:00.190 all those are operating costs necessary to keep 00:09:00.190 --> 00:09:02.289 the building functional and rented okay so far 00:09:02.289 --> 00:09:05.929 so good that all seems logical now what is excluded 00:09:05.929 --> 00:09:08.370 what do we purposefully leave out of the mass 00:09:08.370 --> 00:09:10.809 that might surprise people this is the critical 00:09:10.809 --> 00:09:15.029 distinction first you exclude depreciation That's 00:09:15.029 --> 00:09:17.570 a non -cash tax write -off. It's an accounting 00:09:17.570 --> 00:09:20.190 concept, not a real expense. Okay, makes sense. 00:09:20.330 --> 00:09:22.750 You also exclude the owner's personal income 00:09:22.750 --> 00:09:25.610 taxes. And this is the big one, the one that 00:09:25.610 --> 00:09:28.110 everyone gets wrong. You exclude mortgage interest, 00:09:28.370 --> 00:09:31.470 also known as debt service. Okay, I have to stop 00:09:31.470 --> 00:09:33.169 here because we just hit the most controversial 00:09:33.169 --> 00:09:37.009 part of the formula. You were telling me we exclude 00:09:37.009 --> 00:09:39.490 the mortgage payment. Correct. You do not subtract 00:09:39.490 --> 00:09:42.549 debt service when calculating net operating income. 00:09:42.789 --> 00:09:45.100 But hold on a second. That sounds completely 00:09:45.100 --> 00:09:47.700 insane. If I buy a building, the mortgage is 00:09:47.700 --> 00:09:49.740 the single biggest check I write every single 00:09:49.740 --> 00:09:52.580 month. It leaves my bank account. It is a very, 00:09:52.620 --> 00:09:55.539 very real cost. If I ignore it, aren't I just 00:09:55.539 --> 00:09:57.399 lying to myself about how much money I'm actually 00:09:57.399 --> 00:09:59.460 making? You're asking the exact right question. 00:09:59.620 --> 00:10:02.000 If you were calculating your personal cash flow, 00:10:02.080 --> 00:10:03.940 the money you can take home and spend on groceries, 00:10:04.179 --> 00:10:06.539 then yes, ignoring the mortgage would be lying. 00:10:06.740 --> 00:10:09.360 But remember our mission. The cap rate isn't 00:10:09.360 --> 00:10:11.539 about you. It's about the building. Make that 00:10:11.539 --> 00:10:13.159 make sense for me. I'm struggling with this. 00:10:13.480 --> 00:10:15.720 Why does the building not care about my mortgage? 00:10:15.980 --> 00:10:18.080 Okay, let me give you an analogy. Picture two 00:10:18.080 --> 00:10:20.860 identical buildings, building A and building 00:10:20.860 --> 00:10:23.519 B. They are right next to each other, built by 00:10:23.519 --> 00:10:26.639 the same contractor, same floor plans, same tenants, 00:10:26.759 --> 00:10:29.820 same rent. They both bring in $100 ,000 a year 00:10:29.820 --> 00:10:32.340 in NOI. Okay, they're identical twins. Exactly. 00:10:32.659 --> 00:10:35.539 Now, building A is bought by a massive pension 00:10:35.539 --> 00:10:37.840 fund, let's say a teacher's retirement fund. 00:10:38.159 --> 00:10:41.649 They have billions in cash. They pay all cash 00:10:41.649 --> 00:10:44.350 for the building. No mortgage. No debt. Must 00:10:44.350 --> 00:10:46.990 be nice. Right. Now, building B is bought by 00:10:46.990 --> 00:10:49.309 a young investor who scrapes together a small 00:10:49.309 --> 00:10:52.509 down payment and borrows 90 % of the purchase 00:10:52.509 --> 00:10:55.049 price from the bank. He's leveraged to the hilt. 00:10:55.190 --> 00:10:57.549 Okay. So building A has no mortgage payment. 00:10:57.690 --> 00:11:00.330 Building B has a massive one. A huge one. So 00:11:00.330 --> 00:11:02.330 if we included the mortgage in the valuation 00:11:02.330 --> 00:11:04.990 calculation, building A would look like a gold 00:11:04.990 --> 00:11:08.419 mine. Huge positive income. Building B would 00:11:08.419 --> 00:11:10.840 look like a total disaster, almost zero income 00:11:10.840 --> 00:11:13.039 because it's all going to the bank to pay the 00:11:13.039 --> 00:11:14.980 loan. Right. On paper, they look like completely 00:11:14.980 --> 00:11:17.440 different investments. But are they physically? 00:11:17.899 --> 00:11:20.580 Are the assets themselves different? They are 00:11:20.580 --> 00:11:22.980 the same pile of bricks. The roofs are the same. 00:11:23.139 --> 00:11:25.840 The tenants are paying the same rent. The buildings 00:11:25.840 --> 00:11:28.019 are performing identically. Right. The bricks 00:11:28.019 --> 00:11:30.720 haven't changed. Only the owner's financial situation 00:11:30.720 --> 00:11:33.360 is different. And that is exactly why we use 00:11:33.360 --> 00:11:36.240 the cap rate. It strips away the financing structure, 00:11:36.480 --> 00:11:39.620 which is unique to each individual buyer, and 00:11:39.620 --> 00:11:42.159 it looks purely at the underlying asset performance. 00:11:42.519 --> 00:11:44.899 It lets you compare assets on an apples -to -apples 00:11:44.899 --> 00:11:47.440 basis. I see. So it allows the pension fund to 00:11:47.440 --> 00:11:49.639 look at BuildingBee and say, I don't care that 00:11:49.639 --> 00:11:51.980 the current owner is broke and overleveraged. 00:11:52.019 --> 00:11:54.820 The machine itself produces $100 ,000 a year. 00:11:55.039 --> 00:11:57.710 Precisely. It isolates the real estate quality 00:11:57.710 --> 00:12:00.090 from the financial engineering. It answers the 00:12:00.090 --> 00:12:03.169 question. If you paid all cash for this asset, 00:12:03.389 --> 00:12:06.350 what would its unlevered yield be? That makes 00:12:06.350 --> 00:12:08.950 total sense. It clarifies the view. It took me 00:12:08.950 --> 00:12:10.929 a minute, but I'm there. But there's another 00:12:10.929 --> 00:12:12.889 trap you mentioned from the source material. 00:12:13.169 --> 00:12:15.889 They called it the undefined trap. Yes, this 00:12:15.889 --> 00:12:18.049 is a fun mathematical quirk that actually teaches 00:12:18.049 --> 00:12:20.090 an important lesson. This happens with inherited 00:12:20.090 --> 00:12:22.570 buildings, right? Right. It's the classic example. 00:12:22.990 --> 00:12:25.570 Let's say your great aunt Mildred leaves you 00:12:25.570 --> 00:12:28.110 a 10 -unit apartment complex in her will. You 00:12:28.110 --> 00:12:31.149 get it for free. Your cost basis, what you paid 00:12:31.149 --> 00:12:34.490 for it, is zero. Best day of my life. Financially, 00:12:34.570 --> 00:12:37.389 yes. But if you try to calculate your return 00:12:37.389 --> 00:12:39.669 on investment based on what you pay... Well, 00:12:39.750 --> 00:12:43.210 the income is, say, $50 ,000. Yeah. And I divide 00:12:43.210 --> 00:12:45.549 that by my cost, which is zero. What happens 00:12:45.549 --> 00:12:47.950 when you divide by zero? The universe implodes. 00:12:47.950 --> 00:12:50.330 It's undefined. Your calculator gives you an 00:12:50.330 --> 00:12:52.769 error message. Exactly. You cannot calculate 00:12:52.769 --> 00:12:55.629 a cap rate based on initial cost if that cost 00:12:55.629 --> 00:12:58.570 is zero. And this brings us to a vital point 00:12:58.570 --> 00:13:01.090 that leads to our next section. Cap rates should 00:13:01.090 --> 00:13:03.950 always... always be calculated based on current 00:13:03.950 --> 00:13:06.929 market value, not your historical cost. Which 00:13:06.929 --> 00:13:09.789 segues perfectly into section three, the time 00:13:09.789 --> 00:13:12.370 value of money and the sneaky, powerful concept 00:13:12.370 --> 00:13:15.269 of opportunity cost. Because this is where people, 00:13:15.429 --> 00:13:17.470 especially long -term owners, trick themselves. 00:13:17.769 --> 00:13:19.970 They do all the time. We call it the 20 -year 00:13:19.970 --> 00:13:22.309 owner scenario. It's a classic mental error. 00:13:22.509 --> 00:13:24.230 Walk us through this one. Okay, let's look at 00:13:24.230 --> 00:13:25.789 the detailed example from our source material. 00:13:26.110 --> 00:13:29.309 An owner, let's call him Frank. bought a building 00:13:29.309 --> 00:13:32.830 20 years ago for $200 ,000. It was a great deal 00:13:32.830 --> 00:13:34.750 at the time. Okay. Frank's feeling pretty good 00:13:34.750 --> 00:13:38.049 about that purchase. He is. Today, that building, 00:13:38.129 --> 00:13:41.429 due to market appreciation, is now worth $400 00:13:41.429 --> 00:13:46.009 ,000. And the NOI, the income it produces after 00:13:46.009 --> 00:13:50.190 expenses, is a very healthy $100 ,000 a year. 00:13:50.570 --> 00:13:52.769 Not bad at all. Frank's doing well. Now, you 00:13:52.769 --> 00:13:55.250 go to Frank and you ask him, Frank, what is your 00:13:55.250 --> 00:13:57.129 return on this building? He'll often look at 00:13:57.129 --> 00:13:58.750 his original checkbook. He'll pull out the old 00:13:58.750 --> 00:14:00.870 file. He remembers the day he wrote that check. 00:14:00.950 --> 00:14:02.970 He does. And he says, well, it's simple. I paid 00:14:02.970 --> 00:14:06.350 $200 ,000 and it makes me $100 ,000 a year. That's 00:14:06.350 --> 00:14:08.889 easy math. I'm making a 50 % return. And he feels 00:14:08.889 --> 00:14:11.830 like a genius. He's probably bragging about his 00:14:11.830 --> 00:14:13.889 50 % return at the golf course. He feels like 00:14:13.889 --> 00:14:16.820 Warren Buffett. But he is wrong. He's fooling 00:14:16.820 --> 00:14:19.240 himself. Why is he wrong? I mean, 100 ,000 divided 00:14:19.240 --> 00:14:22.480 by 200 ,000 is 50%. The math works. The arithmetic 00:14:22.480 --> 00:14:25.519 works, but the economic logic is flawed. He is 00:14:25.519 --> 00:14:28.179 ignoring the $400 ,000 that the building is currently 00:14:28.179 --> 00:14:30.649 worth. He's ignoring the value that's sitting 00:14:30.649 --> 00:14:32.610 right there on the table. What do you mean? By 00:14:32.610 --> 00:14:35.610 choosing to keep the building today, he is effectively 00:14:35.610 --> 00:14:39.429 choosing not to sell it for $400 ,000. That $400 00:14:39.429 --> 00:14:42.330 ,000 is the real amount of capital currently 00:14:42.330 --> 00:14:45.429 tied up in this deal. So the real math, the correct 00:14:45.429 --> 00:14:48.950 math, is the $100 ,000 of income divided by the 00:14:48.950 --> 00:14:51.610 $400 ,000 current value. Which gives you what? 00:14:51.789 --> 00:14:54.610 A 25 % cap rate, which is still amazing, by the 00:14:54.610 --> 00:14:57.019 way. Most investors would kill for that. But 00:14:57.019 --> 00:14:59.659 it's not 50%. It's not 50%. And this is the core 00:14:59.659 --> 00:15:02.320 of opportunity costs. Explain that concept. Think 00:15:02.320 --> 00:15:04.559 of it this way. Every single morning you wake 00:15:04.559 --> 00:15:06.700 up and you don't sell your house, you are effectively 00:15:06.700 --> 00:15:08.899 buying it again at today's market price. Ooh. 00:15:09.699 --> 00:15:12.039 That is an uncomfortable thought. It reframes 00:15:12.039 --> 00:15:14.200 ownership entirely. It is uncomfortable, but 00:15:14.200 --> 00:15:17.019 it's the truth for a rational investor. Frank, 00:15:17.100 --> 00:15:19.240 in our example, is effectively buying that building 00:15:19.240 --> 00:15:22.220 for $400 ,000 every single day by not selling 00:15:22.220 --> 00:15:24.279 it. So the real question isn't what's my return 00:15:24.279 --> 00:15:26.799 on my old money? The question is, is 25 % the 00:15:26.799 --> 00:15:29.259 best return I can get on my $400 ,000 today? 00:15:29.659 --> 00:15:31.960 Right. Could he sell it, take that $400 ,000 00:15:31.960 --> 00:15:35.139 and put it into stocks, into bonds, into a different, 00:15:35.220 --> 00:15:38.169 better building that yields 30 %? Exactly. The 00:15:38.169 --> 00:15:40.889 market doesn't care what you paid in 1995. The 00:15:40.889 --> 00:15:42.710 market only cares what that capital is worth 00:15:42.710 --> 00:15:44.909 today and what it could be doing instead. That 00:15:44.909 --> 00:15:48.009 is a huge mindset shift. It stops you from being 00:15:48.009 --> 00:15:49.690 sentimental about an asset. Oh, I've owned this 00:15:49.690 --> 00:15:52.029 for 30 years. That doesn't matter. Real estate 00:15:52.029 --> 00:15:55.149 is no place for sentimentality if your goal is 00:15:55.149 --> 00:15:57.809 to maximize returns. So let's move to Section 00:15:57.809 --> 00:16:01.139 4. The three levers. We know what the cap rate 00:16:01.139 --> 00:16:03.440 is. We know how to calculate it properly. But 00:16:03.440 --> 00:16:06.019 what actually moves it? Why is it 5 % in one 00:16:06.019 --> 00:16:08.899 city and 10 % in another? Why does it change 00:16:08.899 --> 00:16:11.720 from year to year? There is a scary -looking 00:16:11.720 --> 00:16:14.899 formula in our notes. Cap rate, risk -free rate, 00:16:15.019 --> 00:16:17.940 plus risk premium growth rate. It looks complex, 00:16:17.980 --> 00:16:20.039 and the full academic version is even worse. 00:16:20.159 --> 00:16:22.379 But we can simplify this into three core drivers. 00:16:22.679 --> 00:16:24.399 Think of them as three levers that are constantly 00:16:24.399 --> 00:16:26.500 pulling the rate up or pushing it down. Okay, 00:16:26.519 --> 00:16:28.779 good. Let's play a game with this. I'll name 00:16:28.779 --> 00:16:30.519 the lever from our research, you explain how 00:16:30.519 --> 00:16:32.220 it works, and then I'm going to give you a hypothetical 00:16:32.220 --> 00:16:34.320 building scenario and you tell me how the lever 00:16:34.320 --> 00:16:36.580 applies. I like it. Let's do it. Okay. Lever 00:16:36.580 --> 00:16:39.759 number one, the opportunity cost of capital. 00:16:40.139 --> 00:16:42.200 This is usually tied to what's called the risk 00:16:42.200 --> 00:16:44.960 free rate which is the yield on government bonds 00:16:44.960 --> 00:16:47.559 like a 10 year U .S. Treasury. Why that because 00:16:47.559 --> 00:16:50.600 commercial real estate competes with other assets 00:16:50.600 --> 00:16:53.740 for investor dollars. If I can get a 5 percent 00:16:53.740 --> 00:16:56.320 guaranteed return by buying a U .S. Treasury 00:16:56.320 --> 00:16:59.259 bond backed by the full faith and credit of the 00:16:59.259 --> 00:17:01.970 government. Why would I buy a building for a 00:17:01.970 --> 00:17:04.710 4 % return and have to deal with tenants, toilets, 00:17:04.869 --> 00:17:06.750 and taxes? You wouldn't. It's a no -brainer. 00:17:06.849 --> 00:17:09.890 So if bond rates go up, making them more attractive... 00:17:09.890 --> 00:17:12.269 Then demand for real estate goes down. Investors 00:17:12.269 --> 00:17:14.369 move their money to the safer, easier asset. 00:17:14.609 --> 00:17:17.329 Exactly. And when demand for real estate falls, 00:17:17.589 --> 00:17:19.769 prices fall. And as we know from our formula, 00:17:19.950 --> 00:17:22.569 if the value, the denominator, goes down, the 00:17:22.569 --> 00:17:25.569 cap rate goes up. Okay, scenario time. I am selling 00:17:25.569 --> 00:17:28.029 a generic, boring office building in a generic 00:17:28.029 --> 00:17:31.029 city. It's fine. It's okay. Class B, 90 % occupied. 00:17:31.250 --> 00:17:33.549 But suddenly, the Federal Reserve hikes interest 00:17:33.549 --> 00:17:36.269 rates by 2 % to fight inflation. What happens 00:17:36.269 --> 00:17:38.829 to my cap rate? Your cap rate almost certainly 00:17:38.829 --> 00:17:41.150 goes up. Because your building is boring and 00:17:41.150 --> 00:17:43.390 stable, it doesn't have some crazy growth story. 00:17:43.809 --> 00:17:46.529 It's competing directly with those bonds for 00:17:46.529 --> 00:17:50.529 capital. If bonds now pay more, you have to offer 00:17:50.529 --> 00:17:53.609 a better yield to compete. The only way to do 00:17:53.609 --> 00:17:56.329 that is to lower your price, which pushes your 00:17:56.329 --> 00:18:00.539 cap rate up. Ouch. The Fed just cost me money, 00:18:00.619 --> 00:18:02.880 even though my building didn't change at all. 00:18:02.960 --> 00:18:05.420 The Fed just repriced your entire asset class. 00:18:05.680 --> 00:18:08.579 OK, lever number two, growth expectations. This 00:18:08.579 --> 00:18:11.319 is the greed lever, the sexy one. I like this 00:18:11.319 --> 00:18:13.900 lever. If rents in a market are expected to rise 00:18:13.900 --> 00:18:16.519 dramatically, say you're in a booming tech hub 00:18:16.519 --> 00:18:20.150 like Austin or Miami in the right year. Investors 00:18:20.150 --> 00:18:22.890 will pay a huge premium to get in today. They're 00:18:22.890 --> 00:18:24.950 willing to accept a tiny amount of income right 00:18:24.950 --> 00:18:26.970 now because they believe that income will double 00:18:26.970 --> 00:18:29.930 or triple in five years. Yes. So a higher price 00:18:29.930 --> 00:18:32.009 for the same income equals a lower cap rate. 00:18:32.130 --> 00:18:34.250 It's like buying a growth stock. You buy a Tesla 00:18:34.250 --> 00:18:36.369 or Amazon back in the day. You're not buying 00:18:36.369 --> 00:18:38.450 it for the dividend they pay now, which is zero. 00:18:38.930 --> 00:18:41.029 You're buying it for the future earnings. It's 00:18:41.029 --> 00:18:44.309 the exact same logic. A low cap rate often signals 00:18:44.309 --> 00:18:46.509 the market has very high growth expectations. 00:18:47.009 --> 00:18:50.059 OK, scenario. I own a pretty standard warehouse. 00:18:50.380 --> 00:18:52.579 But it's not just any warehouse. It's located 00:18:52.579 --> 00:18:54.859 right next to the main airport, in a city where 00:18:54.859 --> 00:18:57.349 a major tech company just announced they are 00:18:57.349 --> 00:18:59.349 building their new massive headquarters. The 00:18:59.349 --> 00:19:01.849 growth lever gets pulled all the way down hard. 00:19:02.650 --> 00:19:04.390 Investors will be falling over each other to 00:19:04.390 --> 00:19:06.150 buy that warehouse. They'll bid the price up 00:19:06.150 --> 00:19:08.910 so high that the CAC rate might drop to 3 % or 00:19:08.910 --> 00:19:12.069 even 2 .5%. Wow. They don't care that the yield 00:19:12.069 --> 00:19:14.230 is low today because they know that in five years, 00:19:14.410 --> 00:19:16.769 every company that wants to be near that new 00:19:16.769 --> 00:19:19.250 headquarters will need logistics space, and your 00:19:19.250 --> 00:19:21.150 warehouse will be a gold mine. They're buying 00:19:21.150 --> 00:19:24.069 the future. Got it. Okay, last one. Lever number 00:19:24.069 --> 00:19:27.640 three. Risk. The fear lever. The opposite of 00:19:27.640 --> 00:19:30.099 the greed lever. Right. Risk moves in tandem 00:19:30.099 --> 00:19:32.339 with cap rates. It's a direct relationship. If 00:19:32.339 --> 00:19:34.680 you have a high risk asset, maybe has a single 00:19:34.680 --> 00:19:37.279 tenant, a startup that might go bankrupt or it's 00:19:37.279 --> 00:19:40.680 in a bad location in a shrinking city, an investor 00:19:40.680 --> 00:19:42.779 is going to demand a much higher return to take 00:19:42.779 --> 00:19:45.259 on that risk. They need a bigger cushion in case 00:19:45.259 --> 00:19:47.720 things go wrong. You got it. High risk equals 00:19:47.720 --> 00:19:52.019 high cap rate. And the flip side is true. Low 00:19:52.019 --> 00:19:55.789 risk like. A brand new building in a prime location 00:19:55.789 --> 00:19:57.849 leased to the federal government for 20 years. 00:19:58.130 --> 00:20:00.450 That's going to have a very low cap rate. Okay, 00:20:00.490 --> 00:20:02.869 scenario. I own a shopping mall. It was built 00:20:02.869 --> 00:20:05.970 in 1980. The anchor tenant was a Sears, and they 00:20:05.970 --> 00:20:08.089 just went out of business and closed. The roof 00:20:08.089 --> 00:20:11.210 leaks. And it's located in a town where the main 00:20:11.210 --> 00:20:13.369 factory just shut down and the population is 00:20:13.369 --> 00:20:16.910 dropping. Oh, boy. That is the fear liver maxed 00:20:16.910 --> 00:20:18.970 out and then broken off. That is a trifecta of 00:20:18.970 --> 00:20:21.710 pain. What happens to my cap rate? No one wants 00:20:21.710 --> 00:20:24.019 that headache. To sell that property, you would 00:20:24.019 --> 00:20:26.299 have to drop the price so low that you're offering 00:20:26.299 --> 00:20:29.000 a massive cap rate, maybe 12%, 14%. It could 00:20:29.000 --> 00:20:31.119 even be higher. You are basically paying someone 00:20:31.119 --> 00:20:33.779 to take this disaster off your hands, and you're 00:20:33.779 --> 00:20:36.380 compensating them with a huge yield for the sleepless 00:20:36.380 --> 00:20:38.440 nights they're about to have. So if I'm a buyer 00:20:38.440 --> 00:20:41.200 and I see a building with an 8 % cap rate in 00:20:41.200 --> 00:20:42.720 a market where everything else is trading at 00:20:42.720 --> 00:20:45.779 5%, I shouldn't just think, good deal. I should 00:20:45.779 --> 00:20:47.519 be thinking, what's wrong with it? That's the 00:20:47.519 --> 00:20:49.880 professional mindset. Your first thought shouldn't 00:20:49.880 --> 00:20:53.210 be... wow, a bargain. It should be, what is the 00:20:53.210 --> 00:20:56.329 market seeing that I am not? Is the tenant about 00:20:56.329 --> 00:20:59.309 to leave? Is the building about to need a new 00:20:59.309 --> 00:21:01.869 HVAC system? Is there new competition being built 00:21:01.869 --> 00:21:04.609 across the street? That 8 % is a warning sign 00:21:04.609 --> 00:21:06.990 as much as it is an invitation. So there's this 00:21:06.990 --> 00:21:08.809 constant tug of war between these three things, 00:21:08.910 --> 00:21:12.930 interest rates, growth, and risk. Always. And 00:21:12.930 --> 00:21:14.789 the best investors are the ones who can correctly 00:21:14.789 --> 00:21:17.329 identify which lever is pulling the hardest at 00:21:17.329 --> 00:21:19.410 any given moment in the market cycle. Okay, now 00:21:19.410 --> 00:21:22.829 we get to do some magic. Section five, valuation 00:21:22.829 --> 00:21:26.430 and what you call the reverse math. This is what 00:21:26.430 --> 00:21:28.809 appraisers and investors use to basically figure 00:21:28.809 --> 00:21:30.869 out what a property is worth, right? It feels 00:21:30.869 --> 00:21:32.390 like magic, but it's just a little bit of algebra. 00:21:32.569 --> 00:21:34.769 This is called the direct capitalization approach 00:21:34.769 --> 00:21:37.329 to valuation. So usually we have the formula 00:21:37.329 --> 00:21:40.440 income value equal cap rate. But we can just 00:21:40.440 --> 00:21:42.380 flip the equation around. Algebra is our friend 00:21:42.380 --> 00:21:44.619 here. If we rearrange the terms, the formula 00:21:44.619 --> 00:21:47.700 becomes value NOI cap rate. So if I know how 00:21:47.700 --> 00:21:49.740 much money a building makes, and I know what 00:21:49.740 --> 00:21:51.900 the market cap rate is for that type of building 00:21:51.900 --> 00:21:54.500 in that location, I can tell you exactly what 00:21:54.500 --> 00:21:56.359 it should sell for. You can get a very good estimate. 00:21:56.559 --> 00:21:58.700 Try it with an example. Let's say you're looking 00:21:58.700 --> 00:22:01.799 at a small apartment building, and you've determined 00:22:01.799 --> 00:22:05.319 it produces $10 ,000 in NOI per year. Okay, small 00:22:05.319 --> 00:22:08.559 building. $10 ,000 in income after expenses. 00:22:08.839 --> 00:22:10.720 And you do your research, you look at recent 00:22:10.720 --> 00:22:13.140 sales of similar buildings in the area, and you 00:22:13.140 --> 00:22:15.920 see they're all selling at roughly a 7 % cap 00:22:15.920 --> 00:22:19.700 rate. So I take my income, $10 ,000, and I divide 00:22:19.700 --> 00:22:22.019 it by the market cap rate, .07. And what do you 00:22:22.019 --> 00:22:24.819 get? Let me pull up a calculator. $10 ,000 divided 00:22:24.819 --> 00:22:31.259 by .07 is $142 ,857. That is the estimated value 00:22:31.259 --> 00:22:33.740 of your building. Simple as that. Now here is 00:22:33.740 --> 00:22:35.940 where it gets really crazy. This is the value 00:22:35.940 --> 00:22:38.279 -add strategy that every real estate guru on 00:22:38.279 --> 00:22:40.099 the Internet talks about. Ah, yes. Let's say 00:22:40.099 --> 00:22:41.880 I buy that building. I go in, I spend a little 00:22:41.880 --> 00:22:44.640 money, I paint the walls, put in some nicer countertops, 00:22:44.680 --> 00:22:46.680 and I'm able to raise the rents across the board. 00:22:47.500 --> 00:22:50.519 Let's say I increase the NOI from $10 ,000 a 00:22:50.519 --> 00:22:53.759 year to $12 ,000 a year, just a small $2 ,000 00:22:53.759 --> 00:22:56.700 increase. Okay, a very achievable goal. Now run 00:22:56.700 --> 00:22:58.900 the math again. All right, new NOI is $12 ,000. 00:22:59.119 --> 00:23:02.700 The market cap rate is still 7%. So $12 ,000 00:23:02.700 --> 00:23:08.259 divided by .07 is $171 ,428. So wait a minute. 00:23:08.319 --> 00:23:11.019 You increase the annual income by only $2 ,000, 00:23:11.200 --> 00:23:13.640 but you increase the value of the entire building 00:23:13.640 --> 00:23:15.890 by... What's the difference there? Almost $30 00:23:15.890 --> 00:23:18.589 ,000. That is the multiplier effect. That's incredible. 00:23:18.829 --> 00:23:22.150 It is. At a 7 % cap rate, every single dollar 00:23:22.150 --> 00:23:24.069 of new income you add to the property creates 00:23:24.069 --> 00:23:26.990 about $14 of value. If you were in a market with 00:23:26.990 --> 00:23:30.349 a 5 % cap rate, every dollar of income creates 00:23:30.349 --> 00:23:33.170 $20 of value. That explains why investors are 00:23:33.170 --> 00:23:35.349 so obsessed with raising rents and cutting costs. 00:23:35.589 --> 00:23:37.569 It's not just about the extra cash flow each 00:23:37.569 --> 00:23:39.569 month. It's about this explosive effect on the 00:23:39.569 --> 00:23:42.450 resale value of the asset. Exactly. Bye. Oh, 00:23:42.450 --> 00:23:44.470 no. There's always a but. Multiplier works both 00:23:44.470 --> 00:23:46.150 ways. Let's say you do nothing to the building. 00:23:46.289 --> 00:23:48.650 Your income stays at $10 ,000, but the market 00:23:48.650 --> 00:23:51.650 changes. The Fed raises rates. So just a moment 00:23:51.650 --> 00:23:54.329 ago, your building was worth over $142 ,000. 00:23:54.650 --> 00:23:57.809 Now it's worth $100 ,000. You just lost over 00:23:57.809 --> 00:24:00.450 $40 ,000 in value, and the building's income 00:24:00.450 --> 00:24:03.829 didn't change by a single penny. Whoa. That is 00:24:03.829 --> 00:24:06.250 terrifying. Your net worth can get hammered by 00:24:06.250 --> 00:24:08.529 market forces completely outside your control. 00:24:08.730 --> 00:24:11.029 That is the power and the danger of the cap rate. 00:24:11.170 --> 00:24:13.549 A small shift in that rate, just two or three 00:24:13.549 --> 00:24:16.329 percentage points, can wipe out nearly 30 % of 00:24:16.329 --> 00:24:18.789 your equity. This is why real estate cycles can 00:24:18.789 --> 00:24:20.730 be so brutal. You can be running the building 00:24:20.730 --> 00:24:23.069 perfectly, collecting all your rent, but if interest 00:24:23.069 --> 00:24:25.910 rates rise or market sentiment sours, your asset 00:24:25.910 --> 00:24:28.549 value can evaporate. That is a perfect, if terrifying, 00:24:28.730 --> 00:24:32.190 segue to section six, historical trends and the 00:24:32.190 --> 00:24:34.789 danger. Because we have seen this movie before. 00:24:34.869 --> 00:24:36.609 We certainly have. Let's look at the data from 00:24:36.609 --> 00:24:37.930 the Wall Street Journal that was mentioned in 00:24:37.930 --> 00:24:39.549 our source stack. It's a classic case study. 00:24:39.690 --> 00:24:42.950 The lead up to the 2007 -2008 crash. Exactly. 00:24:43.210 --> 00:24:46.430 Between 2001 and 2007, we saw something unprecedented 00:24:46.430 --> 00:24:49.009 in the commercial real estate market. The average 00:24:49.009 --> 00:24:51.150 cap rate for office buildings in central business 00:24:51.150 --> 00:24:53.490 districts dropped from about 10 % all the way 00:24:53.490 --> 00:24:58.490 down to 5 .5%. A drop from 10 % to 5 .5%. That 00:24:58.490 --> 00:25:00.990 means prices skyrocketed relative to the income 00:25:00.990 --> 00:25:03.130 they were producing. Prices nearly doubled purely 00:25:03.130 --> 00:25:05.609 on what we call cap rate compression. It was 00:25:05.609 --> 00:25:08.690 a mania. Money was cheap. Optimism was high. 00:25:08.869 --> 00:25:10.970 And people were paying more and more for the 00:25:10.970 --> 00:25:13.970 same dollar of income. And there was one specific 00:25:13.970 --> 00:25:16.829 deal that stands out as the poster child for 00:25:16.829 --> 00:25:19.150 this whole era of mania. We have to talk about 00:25:19.150 --> 00:25:21.710 the Stuyvesant Town deal. Stuyvesant Town and 00:25:21.710 --> 00:25:24.630 Peter Cooper Village in New York City. This story 00:25:24.630 --> 00:25:27.250 is legendary in real estate circles. It's the 00:25:27.250 --> 00:25:29.450 ghost story investors tell their junior analysts 00:25:29.450 --> 00:25:31.769 around the campfire. Set the scene for us. It's 00:25:31.769 --> 00:25:34.970 2006. The market is absolutely frothy, and a 00:25:34.970 --> 00:25:37.089 partnership of Tishman Spire and BlackRock decides 00:25:37.089 --> 00:25:39.650 to buy this massive apartment complex in Manhattan. 00:25:39.710 --> 00:25:43.329 We're talking 110 buildings, over 11 ,000 apartments. 00:25:43.670 --> 00:25:47.599 The price tag was $5 .4 billion. At the time, 00:25:47.599 --> 00:25:49.740 it was the single biggest real estate deal in 00:25:49.740 --> 00:25:51.680 U .S. history. And when analysts ran the math 00:25:51.680 --> 00:25:53.660 on what they paid versus the income the property 00:25:53.660 --> 00:25:55.980 was generating at the time, the resulting cap 00:25:55.980 --> 00:25:59.480 rate was, wait for it, 3 .1%. 3 .1%. I want you 00:25:59.480 --> 00:26:02.579 to contextualize that for me. Why is a 3 .1 % 00:26:02.579 --> 00:26:05.869 cap rate so unbelievably scary? Well, let's go 00:26:05.869 --> 00:26:07.470 back to lever number one, the risk -free rate 00:26:07.470 --> 00:26:10.910 we talked about. At that time in late 2006, you 00:26:10.910 --> 00:26:14.109 could buy a 10 -year U .S. Treasury bond and 00:26:14.109 --> 00:26:19.430 get a yield of about 4 .6 % or 4 .7%. Wait. Pause. 00:26:20.009 --> 00:26:22.490 Let me make sure I understand this. I could lend 00:26:22.490 --> 00:26:24.789 money to the United States government, a guaranteed 00:26:24.789 --> 00:26:27.789 return, zero risk of default, and get nearly 00:26:27.789 --> 00:26:31.319 5 % interest. Correct. But these incredibly smart 00:26:31.319 --> 00:26:34.339 investors at Tishman Spire and BlackRock bought 00:26:34.339 --> 00:26:36.819 a huge, complicated building full of toilets 00:26:36.819 --> 00:26:40.019 and tenants for a 3 % return. That's a negative 00:26:40.019 --> 00:26:42.220 risk premium. That makes absolutely zero sense 00:26:42.220 --> 00:26:44.059 on the surface. On the surface, it's financial 00:26:44.059 --> 00:26:47.420 madness. Why accept 3 % on a risky asset when 00:26:47.420 --> 00:26:53.480 you can get almost 5 % on a risk -free one? higher 00:26:53.480 --> 00:26:55.400 interest rate than the building was yielding, 00:26:55.400 --> 00:26:57.440 they were guaranteed to lose money on every dollar 00:26:57.440 --> 00:26:59.579 they borrowed from day one. So why on earth did 00:26:59.579 --> 00:27:02.299 they do it? Were they just stupid? No, they were 00:27:02.299 --> 00:27:05.000 incredibly ambitious. They were pulling the growth 00:27:05.000 --> 00:27:07.519 lever we talked about earlier. They weren't buying 00:27:07.519 --> 00:27:10.200 the property for that 3 % yield. They were betting 00:27:10.200 --> 00:27:12.339 that the 3 % was a lie. What do you mean a lie? 00:27:12.579 --> 00:27:14.920 They believed the income was artificially low. 00:27:15.099 --> 00:27:18.099 A huge portion of Stuyvesant town was rent stabilized. 00:27:18.539 --> 00:27:20.400 You had tenants who had been there for decades 00:27:20.400 --> 00:27:23.640 paying 1980s prices for rent. The investor's 00:27:23.640 --> 00:27:26.940 entire thesis was, we are going to go in, find 00:27:26.940 --> 00:27:29.099 ways to get these people out, deregulate the 00:27:29.099 --> 00:27:31.079 units, and bring all the rents up to the much 00:27:31.079 --> 00:27:33.000 higher market rates. So they thought they could 00:27:33.000 --> 00:27:35.859 aggressively double or triple the NOI in just 00:27:35.859 --> 00:27:38.720 a few years. Exactly. They priced the deal not 00:27:38.720 --> 00:27:40.779 on what it was, but on what they hoped it would 00:27:40.779 --> 00:27:43.359 become. They paid for a perfect future. They 00:27:43.359 --> 00:27:45.619 thought that 3 .1 percent yield would quickly 00:27:45.619 --> 00:27:48.000 turn into a 10 percent or 12 percent yield through 00:27:48.000 --> 00:27:50.380 that aggressive growth. And as we know from history, 00:27:50.519 --> 00:27:53.940 that perfect future didn't materialize. Not even 00:27:53.940 --> 00:27:56.740 close. The Tenants Association fought back tooth 00:27:56.740 --> 00:27:59.519 and nail. The courts blocked their deregulation 00:27:59.519 --> 00:28:03.079 plans. And then the knockout blow. The 2008 financial 00:28:03.079 --> 00:28:05.960 crisis hit. The growth lever snapped off in their 00:28:05.960 --> 00:28:07.940 hand. And because they had billions and billions 00:28:07.940 --> 00:28:10.019 of dollars in debt. The negative leverage just 00:28:10.019 --> 00:28:12.259 ate them alive. They defaulted, walked away, 00:28:12.440 --> 00:28:15.140 handed the keys back to the lenders. Billions 00:28:15.140 --> 00:28:17.640 of dollars in investor equity just vaporized. 00:28:17.779 --> 00:28:20.559 It is the ultimate lesson in real estate. A low 00:28:20.559 --> 00:28:23.400 cap rate is often disguised as safety, but it 00:28:23.400 --> 00:28:25.539 can actually be a measure of speculative mania. 00:28:25.579 --> 00:28:28.470 Wow. And then the rebound. What happened after 00:28:28.470 --> 00:28:30.869 the crash, say, in late 2009? The fear lever 00:28:30.869 --> 00:28:33.069 took over. Cap rates shot back up dramatically. 00:28:33.410 --> 00:28:35.589 The data shows that office buildings in central 00:28:35.589 --> 00:28:38.009 business districts went from that 5 .5 % low 00:28:38.009 --> 00:28:40.869 back up to 8 .8%. Apartment buildings went back 00:28:40.869 --> 00:28:44.150 up to 7 .36%. Prices fell faster than rents. 00:28:44.150 --> 00:28:46.170 Much faster. The market was correcting. It was 00:28:46.170 --> 00:28:48.490 resetting the risk premium to a more sane level. 00:28:48.750 --> 00:28:50.789 Now, let's bring it to a more modern context. 00:28:51.470 --> 00:28:54.549 We have data from a CBRE survey from early 2021. 00:28:55.210 --> 00:28:57.789 This gives us a baseline for what normal looked 00:28:57.789 --> 00:29:00.049 like before the recent inflation spike and rate 00:29:00.049 --> 00:29:03.269 hikes. Right. In early 2021, multifamily housing 00:29:03.269 --> 00:29:05.170 apartments were trading at cap rates between 00:29:05.170 --> 00:29:09.170 3 .5 percent and 5 .0 percent. That's very low 00:29:09.170 --> 00:29:13.000 again. High demand perceived as very safe. Extremely 00:29:13.000 --> 00:29:15.220 high demand. People always need a place to live. 00:29:15.359 --> 00:29:17.460 It's considered the most defensive asset class. 00:29:17.720 --> 00:29:19.519 What about urban office buildings at that time? 00:29:19.680 --> 00:29:23.059 They were in the range of 4 .5 % to 6 .5%. A 00:29:23.059 --> 00:29:25.279 bit higher, a bit more risk with the rise of 00:29:25.279 --> 00:29:27.759 remote work. And retail, malls and shopping centers. 00:29:27.900 --> 00:29:31.799 That was trading from 5 .0 % to 7 .0%. Retail 00:29:31.799 --> 00:29:34.019 is generally seen as riskier because of the Amazon 00:29:34.019 --> 00:29:36.339 effect and changing shopping habits, so investors 00:29:36.339 --> 00:29:38.690 demand a higher return to own it. It's fascinating 00:29:38.690 --> 00:29:40.630 to see how the different asset classes stack 00:29:40.630 --> 00:29:42.990 up, each with its own risk profile reflected 00:29:42.990 --> 00:29:45.269 in its cap rate. You can read the entire story 00:29:45.269 --> 00:29:47.230 of the economy just by looking at the spread 00:29:47.230 --> 00:29:49.769 between those numbers. Okay, let's move into 00:29:49.769 --> 00:29:53.569 the final stretch, Section 7, Advanced Concepts. 00:29:53.569 --> 00:29:55.289 We're going to talk about reversionary value 00:29:55.289 --> 00:29:58.079 and total return. This sounds like the graduate 00:29:58.079 --> 00:30:00.579 level course. It is, but it's not as complicated 00:30:00.579 --> 00:30:02.599 as it sounds. So far, we've mostly talked about 00:30:02.599 --> 00:30:05.440 the current income, which in industry terms is 00:30:05.440 --> 00:30:07.400 often called passing rent, what the tenants are 00:30:07.400 --> 00:30:09.180 actually paying right now. Okay, passing rent. 00:30:09.299 --> 00:30:11.940 But a professional valuer, an appraiser, also 00:30:11.940 --> 00:30:14.759 looks at something called an ERV. ERV. Estimated 00:30:14.759 --> 00:30:18.359 rental value. This is what the space could theoretically 00:30:18.359 --> 00:30:21.500 rent for in the open market today if it were 00:30:21.500 --> 00:30:23.960 vacant and you were signing a new lease. Ah, 00:30:24.180 --> 00:30:27.259 okay. So if I have a tenant who signed a five 00:30:27.259 --> 00:30:29.759 year lease four years ago and they're paying 00:30:29.759 --> 00:30:32.660 $20 a square foot, but the market for new leases 00:30:32.660 --> 00:30:35.539 is now $40 a square foot. Your passing rent is 00:30:35.539 --> 00:30:39.099 $20, but your ERV is $40. The huge difference 00:30:39.099 --> 00:30:41.500 between the two is the reversionary value. It's 00:30:41.500 --> 00:30:44.460 the hidden locked in upside potential. When that 00:30:44.460 --> 00:30:46.970 lease expires in one year. the value of that 00:30:46.970 --> 00:30:49.730 income stream reverts to the much higher market 00:30:49.730 --> 00:30:52.490 level. So a savvy investor might look at a building 00:30:52.490 --> 00:30:54.829 with a low cap rate based on its current income, 00:30:55.009 --> 00:30:58.410 knowing that the real cap rate based on ERV is 00:30:58.410 --> 00:31:01.140 actually much higher. Exactly. They are hunting 00:31:01.140 --> 00:31:03.279 for that spread. They look for a mark to market 00:31:03.279 --> 00:31:06.279 opportunities. Conversely, if the passing rent 00:31:06.279 --> 00:31:08.920 is equal to the ERV, the building is said to 00:31:08.920 --> 00:31:12.160 be rack rented. Rack rented. That sounds painful. 00:31:12.359 --> 00:31:15.000 It just means it's fully rented at current market 00:31:15.000 --> 00:31:17.640 rates. There's no hidden upside in the leases. 00:31:17.640 --> 00:31:20.180 What you see is what you get. Got it. And then 00:31:20.180 --> 00:31:22.099 there's the idea of total return because the 00:31:22.099 --> 00:31:24.019 cap rate is just the income part of the equation, 00:31:24.160 --> 00:31:25.779 right? Right. The cap rate is like the dividend 00:31:25.779 --> 00:31:28.200 from a stock. But we also care about the stock 00:31:28.200 --> 00:31:30.720 price going up or down. We care about appreciation. 00:31:31.599 --> 00:31:33.940 So how do you calculate total return? The simple 00:31:33.940 --> 00:31:37.339 formula is total return, cap rate, plus the change 00:31:37.339 --> 00:31:39.779 in the asset's value. So if I buy a building 00:31:39.779 --> 00:31:42.900 at an 8 % cap rate, and over the year the building's 00:31:42.900 --> 00:31:45.759 value goes up by 2%. Your total return for that 00:31:45.759 --> 00:31:48.720 year is 10%, 8 plus 2. And if I buy it at an 00:31:48.720 --> 00:31:51.700 8 % cap rate, and the market turns, the value 00:31:51.700 --> 00:31:56.099 drops by 2%. Your total return is only 6%. Eight 00:31:56.099 --> 00:31:59.740 minus two. You still got your income, but the 00:31:59.740 --> 00:32:03.460 loss in value ate into your overall profit. And 00:32:03.460 --> 00:32:06.279 using leverage, taking out a loan amplifies this 00:32:06.279 --> 00:32:09.279 dramatically. Massively. We talk about LTV loan 00:32:09.279 --> 00:32:13.200 to value. If you put 25 % down and borrow 75%, 00:32:13.200 --> 00:32:16.359 a small 2 % increase in the building's value 00:32:16.359 --> 00:32:19.319 can create an 8 % increase on your actual cash 00:32:19.319 --> 00:32:22.789 equity. But a small 2 % decrease can create an 00:32:22.789 --> 00:32:24.890 8 % loss. A double -edged sword. It cuts both 00:32:24.890 --> 00:32:27.269 ways. Always. Just ask the owners of Stuyvesant 00:32:27.269 --> 00:32:30.009 to. Right. Finally, let's wrap up with Section 00:32:30.009 --> 00:32:33.990 8. Limitations and nuance. Is the cap rate a 00:32:33.990 --> 00:32:37.109 perfect tool? No tool is ever perfect. The single 00:32:37.109 --> 00:32:39.450 biggest flaw of the cap rate is that it is static. 00:32:39.799 --> 00:32:41.960 It's a snapshot in time. Exactly. It looks at 00:32:41.960 --> 00:32:43.660 a single year of income. It doesn't inherently 00:32:43.660 --> 00:32:45.900 account for future rent growth or future capital 00:32:45.900 --> 00:32:48.420 expenditures unless you adjust your expectations 00:32:48.420 --> 00:32:50.799 for the rate itself. It assumes the status quo 00:32:50.799 --> 00:32:52.960 continues forever. And real estate is inefficient, 00:32:53.220 --> 00:32:54.579 right? It's not like the stock market where the 00:32:54.579 --> 00:32:56.500 price is updated every second and is the same 00:32:56.500 --> 00:32:58.940 for everyone. Correct. Real estate markets are 00:32:58.940 --> 00:33:02.480 slow, opaque, and inefficient. Two different 00:33:02.480 --> 00:33:04.380 appraisers can look at the same building and 00:33:04.380 --> 00:33:06.799 come up with two different justifiable cap rates. 00:33:07.339 --> 00:33:09.859 That's why sophisticated investors use multiple 00:33:09.859 --> 00:33:11.839 valuation methods. They don't just rely on this 00:33:11.839 --> 00:33:14.539 one number. Never. They use direct capitalization, 00:33:14.579 --> 00:33:16.420 which is what we've been talking about. But they 00:33:16.420 --> 00:33:18.920 also use market comparables, looking at the price 00:33:18.920 --> 00:33:21.119 per square foot of similar physical buildings. 00:33:21.359 --> 00:33:24.059 And they use replacement cost. How much would 00:33:24.059 --> 00:33:26.859 it cost to build this exact building from scratch 00:33:26.859 --> 00:33:30.420 today? You triangulate to find the truth. You 00:33:30.420 --> 00:33:32.779 never trust just one number. Never. So after 00:33:32.779 --> 00:33:34.960 all that, what does this all mean? Let's summarize 00:33:34.960 --> 00:33:37.359 this journey. I think if we boil it all down, 00:33:37.559 --> 00:33:40.220 the cap rate is the bridge. It's the link that 00:33:40.220 --> 00:33:42.380 connects the physical asset, the bricks, the 00:33:42.380 --> 00:33:44.980 glass, the land, to the world of finance and 00:33:44.980 --> 00:33:47.539 financial return. It encapsulates everything 00:33:47.539 --> 00:33:50.680 we talked about, risk, opportunity cost, and 00:33:50.680 --> 00:33:52.960 growth expectations, all rolled into a single 00:33:52.960 --> 00:33:55.519 elegant percentage. And for you, the listener, 00:33:55.619 --> 00:33:58.329 the practical takeaway is this. Whether you are 00:33:58.329 --> 00:34:00.650 looking at buying a small rental property, investing 00:34:00.650 --> 00:34:03.470 in a big public REIT, or even just reading the 00:34:03.470 --> 00:34:05.890 business section of the newspaper, look at the 00:34:05.890 --> 00:34:09.369 cap rate. It tells you how the market feels about 00:34:09.369 --> 00:34:12.929 that asset. Is it a safe, boring bet, a low cap? 00:34:13.309 --> 00:34:15.730 Or is it a risky venture that could be a home 00:34:15.730 --> 00:34:18.090 run or a strike out a high cap? It turns you 00:34:18.090 --> 00:34:20.590 from a passive observer just looking at a price 00:34:20.590 --> 00:34:23.300 tag into an active analyst. gives you a kind 00:34:23.300 --> 00:34:25.480 of x -ray vision into the deal. It absolutely 00:34:25.480 --> 00:34:28.099 does. I want to leave everyone with a final provocative 00:34:28.099 --> 00:34:30.880 thought based on what we learned about Stuyvesant 00:34:30.880 --> 00:34:33.699 Town and the nature of risk. Go for it. We tend 00:34:33.699 --> 00:34:36.699 to think low numbers are safe. A 3 % cap rate 00:34:36.699 --> 00:34:38.900 sounds safe and stable. It sounds like a government 00:34:38.900 --> 00:34:42.679 bond. But if a cap rate is that low, it implies 00:34:42.679 --> 00:34:45.480 the market is betting heavily, maybe desperately, 00:34:45.619 --> 00:34:48.559 on future growth to justify the astronomical 00:34:48.559 --> 00:34:51.449 price being paid. Correct. The price is baked 00:34:51.449 --> 00:34:53.809 in a perfect future. But as we saw with that 00:34:53.809 --> 00:34:56.090 deal, and as we're seeing in some markets today, 00:34:56.309 --> 00:34:59.269 what happens when the future refuses to cooperate? 00:34:59.989 --> 00:35:02.590 In a world of changing interest rates and economic 00:35:02.590 --> 00:35:06.230 uncertainty, is that supposedly safe, low -cap 00:35:06.230 --> 00:35:10.090 asset actually the riskiest bet of all? That 00:35:10.090 --> 00:35:13.090 is the multi -billion, maybe multi -trillion 00:35:13.090 --> 00:35:15.230 dollar question. When you pay for perfection, 00:35:15.449 --> 00:35:17.690 you better hope you get perfection because there's 00:35:17.690 --> 00:35:20.369 no margin for error. Exactly. Thank you for walking 00:35:20.369 --> 00:35:22.570 us through the DNA of real estate value. My pleasure. 00:35:22.690 --> 00:35:24.909 It was fun. And to our listeners, keep crunching 00:35:24.909 --> 00:35:26.670 those numbers. We'll see you on the next deep 00:35:26.670 --> 00:35:26.889 dive.