Question about Cap Rate

9 Replies

Is it considered standard to include all closing costs, capital outlays (for repairs, improvements, etc), and loan origination fees in addition to the sales price when calculating cap rates?


I know that generally, when people buy multifamily units, they're looking to improve the property in order to increase rental rates/ increase the value of the property (presumably you'd increase the rents so as to maintain the same cap rate whenever you do substantial improvements). 


It seems to me that since the buyer generally uses the previous year's NOI when calculating a fair sales price that any potential repairs/ improvements SHOULDN'T be included when calculating the cap rate.


However, since it's still cash that needs to be spent, I can see why people would include it. 


Thanks,
Patrick 

Updated over 3 years ago

Edit: I understand why loan origination fees/ points wouldn't be included. So, nevermind about those costs.

@Patrick M.  

CAP rate is just the annual gross revenue /purchase price. All the other costs and financing would go into the cash-on-cash return which takes into account more costs. Look into the CoCR if you want a better idea if the property is cash flowing.

I use CAP rate as a quick indicator of if a property is worth it. Others will chime in that are more saavy than myself but hopefully that helps.

@Brock Young 

Let me clarify:


My question is whether additional costs are considered part of the purchase price.


For example, if a multifamily unit is listed at $100,000, but I have to pay $3,000 in closing costs,  would I calculate cap rate using $100,000 or $103,000? If not $103,000, why not?


In short, if I have to pay for the privilege of buying the property, shouldn't I include all costs of acquisition? This is especially confusing since Cap Rate is implicitly a cash flow measure (perpetuity of the NOI), and since closing costs would be paid as an initial outlay (ie part of that cash flow).

@Patrick M. None of those costs are included in cap rate calculations. Purchase price and NOI, that's it.

Also capital expenditures and major repairs are not part of NOI since these go on the balance sheet rather that on the income statement. NOI is only a reflection of how the property actually operates. If you determine that there are significant repair needed then try to negotiate and adjust from the purchase price.

Also cap rate is really just a way to quickly and back of the envelope value a property or compare your purchase against others. If you start looking and wanting to measure your actual returns then use thing like roi, IRR and cash on cash.

Derek Carroll, NorthMarq Capital | [email protected] | 315‑558‑8332 | http://www.realestatefinanceguy.com

And to add to what Derek said, make sure the cap rates for those similar property types include the same (or very similar) income and expense categories. If the selection of a cap rate is done poorly, it could have a material impact on the calculated sales price.

@Patrick M. you can include all those expenses (closing costs, improvements and/or repairs, any fees, points, sales price, etc) when calculating internal rate of return (IRR).

Internal rate of return is a powerful metric because it can evaluate the return for all cash inflows/outflows over the life of your investment. A limitation of cap rate is that it looks at a year versus your entire holding period.

You wrote: In short, if I have to pay for the privilege of buying the property, shouldn't I include all costs of acquisition? --The answer is yes, absolutely. Your cash outlay impacts your investment's return.

How many units are you evaluating? I can help if you have questions on IRR.

I don't think there is a set answer to this question.  

When I am buying a re-position, 500k purchase, 200k rehab with 50k NOI and 2k in closing costs, you guys are saying we would calculate it at a 10 cap rate. I think that is wrong, it should 50k/700k. That 200k is not factored into the cash on cash or IRR.

The closing costs would typically not be included (unless they are unusual).  When you are going to sell it, you would price it based on cap rates in the area... closing costs depend on the Buyer and are non existent with a cash closing.   

Originally posted by @Steve L.:

I don't think there is a set answer to this question.  

When I am buying a re-position, 500k purchase, 200k rehab with 50k NOI and 2k in closing costs, you guys are saying we would calculate it at a 10 cap rate. I think that is wrong, it should 50k/700k. That 200k is not factored into the cash on cash or IRR.

The closing costs would typically not be included (unless they are unusual).  When you are going to sell it, you would price it based on cap rates in the area... closing costs depend on the Buyer and are non existent with a cash closing.   

You would be buying the $50,000 NOI at 10% cap if that indeed was what the market cap was. Then you would do a below the line adjustment of minus $200,000 for rehab so you would only pay $300,000 for this property if a market cap is 10% and the NOI is based on a rehabbed property.

Originally posted by @Patrick M.:

 


It seems to me that since the buyer generally uses the previous year's NOI when calculating a fair sales price that any potential repairs/ improvements SHOULDN'T be included when calculating the cap rate.


 


Thanks,
Patrick 

@Patrick M You won't be calculating YOUR cap rate. You will get the cap rate from cap rate comps. You will then use the market cap rate that best reflects your property and use that cape rate against YOUR NOI to get a market value. Now if you pay more YOU will make a new cap rate comp for others that will reflect a lower market cap rate. If you negotiate a lower price you will set a higher than market rate cap. Other investors will have to determine whether you know what you are doing or if your purchase reflects a changing of the market cap rates. Of course the proof will be in other sales since one sale does not make a market.

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