How are cap rates are calculated and by whom?

[Account Closed]

When valuing a commercial multifamily building based on the income approach, the cap rate relates NOI to value. But my question is how does cap rate come to be and who actually calculates this? How subjective is it?

[Anthony Chara]

@Bjorn Ahlblad is correct. Cap Rate (CR) is not subjective. You just take the Net Operating Income (NOI) which is all the income the property generates and subtract your Operating Expenses for things like Taxes, Insurance, Management, Maintenance, Utilities and Reserves (TIMMUR). This gives you the NOI. Divide the NOI by the Asking Price and you get the Cap Rate.

Do not add in Capital Expenses to your TIMMUR. Large ticket items that you usaully only do every 5-30 years like roofs, landscaping, parking lots, boilers, chillers, etc are some samples of Capital Expenses/Improvements. These affect your cash flow, but not your NOI.

Once you know your CR, this is the % of return you'd get on your property before you take your leverage (loan) into account. Let's say you have $135K of NOI and the seller is asking you to pay $2MM for the property. Take $135K and divide it by $2MM and you get a CR of (135,000/2,000,000) = 0.0675 or 6.75%.

Other investors come into a market looking for certain returns. Over the past 10 or so years, investors have been okay with over paying for some properties in order to take advantage of Bonus Depreciation or as a hedge against inflation which has caused CR's to compress or decrease. If you play with the numbers you'll find that as the NOI stays the same and the asking prices go up, CR's go down meaning investors are okay with less returns in order to get control of the asset. Some are going to be paying for that in the form of foreclosures which have already started. They bought totally based on Proforma numbers with Bridge debt with adjustable interest rates.

Back to CR. Investors are setting the CR range as they buy properties in a particular area. They will slowly go up and down over the course of many years, usually! lol