Basing CAP rate off projected income

[Russell Gronsky]

Hey all, So I was looking at a 10-unit multi-family property the other day online and it was advertising an 8 CAP. But when I ran the numbers, the CAP rate I got was closer to 6. When I asked the broker where the 8 CAP came from, she said it was based off projected NOI. I’ve always evaluated any property or business off actuals, not projected. Is calculating CAP rate off projected NOI an accepted practice in commercial RE? If not, would this be a good point to negotiate a lower purchase price or would I just be spinning my wheels?

[Andrew Johnson]

@Russell Gronsky So there are really a few issues here:

1.) The majority (but not all) cap-rate calculations I've seen from brokers are based on their pro-forma of projected gross rents.  What's more challenging is that they sometimes 'forget' to mention that their projected rents are based on $300K worth of improvements.  And those improvements, of course, aren't accounted for in the purchase price.  So the net result is that it can be far, far, FAR from accurate.  And there's really not much you can do about it except to expect it and get more adept and building your own pro-formas.  

2.) I love, love, LOVE using T-12s but they are far from the be-all and end-all.  Property taxes may increase when you purchase the property, who knows what your insurance costs will be, what your PM charges you vs. them, etc.  And if you have someone that has rehabbed the property and invested in it over the past 12 months you could have a good property and a horrible T-12.  Units could have been vacant for 2 months because of major rehab, not a lack of rentability.  

3.) To take this to the extreme, if I have a newly refurbished vacant 8-plex it does have value.  It may have a lot of value.  But a T-12 is going to be zero or show it has a "cash-flow negative" property.  That doesn't mean it's worthless, just that the T-12 doesn't tell the whole story.  

4.) By the way, you can manipulate a T-12 pretty easily but pushing everything through cap-ex improvements to drive down maintenance costs.  Don't repair, replace and you get to manipulate that T-12 in an "acceptable" way.  Decide to skip the quarterly pest control this year?  Sure.  Decide to mow the lawn once a month instead of twice a month this year?  Sure.  Don't repair the dishwasher for $70, replace it for $200?  Sure.

The bottom line, I suppose, is that many times there are some elements of truth in a projected pro-forma, some elements of truth in a T-12, and your job is to figure out what your "relative" truth is for the property.