TAKING THE MYSTERY OUT OF CAP RATES
Determining Value In Commercial Properties
Quoted CAP rates are like glamour shots. They are what the broker or seller wants you to see. Two words come to mind, “caveat emptor”, or buyer beware. It is up to the buyer to verify all information affecting CAP rates in listed properties.
Trust, but verify.
Have you ever looked at a property that looked great in the pictures, but when you got there it did not live up to expectations? Maybe the flooring was dated? Or the appliances and roof were past their useful life and would soon need to be replaced? The same thing happens when reviewing financials. And the CAP rate is not really what it was reported to be.
When looking at the financials, maybe something was missing? Like property management because the owner handles it?
So why does cap rate matter?
WHAT IS CAP RATE?
Cap rate is the capitalization rate, or rate at which a property pays for itself if no debt financing is used. It is commonly calculated as Net Operating Income divided by the Purchase Price.
Cap Rate = NOI / Purchase Price
HOW IS CAP RATE USED?
Cap rate is one of the simpler parameters we use to evaluate properties we are interested in purchasing. It is a measure of how well an asset performs without accounting for debt service. This allows us to compare the performance of different properties.
The Higher cap rates correspond to higher returns.
We also want the cap rate to be higher than our cost of funds. For example, if a property is operating at a 7 CAP, it does not make sense to pay for it with money costing 8-percent annually.
While higher cap rates indicate a property provides a higher return, the cap rates also indicate a degree of perceived risk.
Class A multi-family properties tend to have very low cap rates because their owners see the property as very low risk. These properties are also the newest with the finest amenities. Repairs should be minimal.
On the other hand, Class D properties may have high cap rates because they are older and in less desirable areas. There may not be any amenities and the repairs will likely be more frequent and extensive. You can learn more about the classes of multi-family in our blog here. LINK
A “MARKET CAP RATE”
Each individual property will have its own individual cap rate, as a ratio of the two numbers, the price paid for the specific property and the net operating income for the individual property.
There is also what might be called a “market cap rate” which would be the normal cap rate for similar properties in that market area.
After looking at a few sold properties in a given geographical area you can get a feel for what the cap rate should be for a given class.
If you can find a broker who has tracked the sales of properties in your area, you can learn what the “market cap rate” seems to be for the kind of property you are evaluating.
This is kind of like finding comparable properties when working with single family homes. Basically, you are asking the question, “In this particular market area what seems to be the cap rate for properties like the one we are exploring?”
A “market cap rate” will give you an idea of the potential value of the property compared with other similar properties. Sometimes the cap rate can be used to screen which properties are worth taking a closer look.
Frequently a broker will quote a “pro forma” cap rate. This is a cap rate that might be attained if a buyer makes certain improvements to the property, raises rents and reduces expenses.
We don’t buy properties based on pro forma data, but rather the actual performance over the last year. And sometimes the stated actual cap rate is based on incomplete information.
SOLVING THE MYSTERY
How do we know if data are missing and the cap rate is inflated? Let’s take a look behind the numbers. We need to confirm or make our best estimate of NOI. The broker should be able to provide a T-12, which is a table showing all the income and expenses for the trailing 12 months. It is broken into categories.
Net Operating Income = Income – Expenses (not including debt service or capital improvements)
Here is the general form to ensure all income and expenses are accounted for.
Gross Potential Income (with all units rented at current rate)
= Rental Income
Add Other Income (such as laundry, utility reimbursement, late fees, pet fees)
Next take a look at the expenses. I like an acronym, TIMUR.
Taxes are based on the purchase price. This can be substantially higher than the current taxes if the owner has held the property for a long time. County tax assessor websites can be useful to estimate what the new amount will be.
Insurance may stay the same or change significantly. The new lender may require something different, possibly flood insurance.
Management should include the cost of a property manager, even if you desire to manage the property yourself. Costs should be for staff and any additional charges for lease-ups, renewals, or other add-on fees.
Utilities include water, sewer, electricity, trash removal, and possibly cable.
Repairs should include any maintenance staff on payroll in addition to any materials or jobs that are outsourced. Larger apartments are able to operate more efficiently in this area with economies of scale and by hiring maintenance personnel qualified to perform HVAC and plumbing repairs. Watch out for lawn maintenance or repairs that are performed by an owner and not accounted for.
Using the T12 and the categories above, what months are missing data? Are all expenses covered? Once any missing information has been determined you are ready to determine the actual NOI and current cap rate.
Use caution not to get carried away with too many details before making an offer. It is more important to account for the larger expenses at this point and submit the offer.
It is not uncommon to find that the broker claimed a certain cap rate for the property than what you determined. You can use the actual NOI and broker’s claimed cap rate to justify your offer price.
Of course there are additional steps to determine cash flow and whether or not a property is a viable purchase. Mortgage payments and reserves for capital expenses need to be subtracted from NOI to get Cash Flow Before Taxes.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.