How trustworthy are cap rates

9 Replies

How do you verify if the owner has included all expenditures to calculate their cap rate? Considering a 16 unit for 560k with an 8.04 cap rate. Is this considered a good cap rate?

You are looking at it backwards.  

The cap rate is a number that is used witb NOI to creatE price.

You need to find out what the standard cap is in tge area and class of bldg  

This is going to be an unpopular statement: Cap rates are over rated!

Why do you care what the cap rate is? So you can compare your deal with someone else's deal?

Everyone has different strategies so one person's 5 cap is another's 10 cap.

I'll explain:

If the seller's brother owns a pest control company and the seller get's it at cost, can you get it at cost?

If the seller has a full time on-site manager in a 16 units building and pay her $100K/year because she happens to be his sister, would you keep her at that pay rate?

When you underwrite a deal you must look at YOUR numbers. The seller's numbers are nice as a reference only but no more than that. If I own a 400 units community across the street from that 16 units I can buy it at a much higher price knowing that my cost of operations will be dramatically lower leveraging the scale I already have across the street. 

Bottom line, look at cash flow and dollar amounts. If YOUR numbers will get you a good cash on cash returns (and good is also subjective) then make the deal. Otherwise, pass on it!

@Andrew Green It is called Due Diligence. Your contract should contain a Due Diligence period  to confirm  numbers provided and also check for issues that may be deal killers. I have seen due diligence lists with 100 items on it. 

Some of the basic things you need to see or do 

  • Tax returns - the owner is not going to overstate income on a tax return
  • rent rolls 
  • bank statements
  • Phase one environmental check
  • Estoppel letters
  • leases
  • copies of contracts with existing vendors

There that only leave about 93 more items

@Andrew Green If you are talking about numbers and calculations found in a listing or broker's Pro Forma then I would say it is not reliable at all. The only numbers you should trust are your own. Then if it is wrong you at least know who is at fault. Most often old expense items-taxes insurance etc will change as soon as the new selling price is used. Things get left out for whatever reason-like water and sewer, garbage, landscaping, snow removal; on and on. You need to look at the total investment, generate your own numbers, and see if it lines up with your investment criteria and goals. All the best!

I am assuming the cap rate is based on the broker's pro forma. Instead, you want to determine the NOI yourself, as well as the NOIs after you take over the property (using historical financial data and assumptions confirmed by your property management company), and find the market cap rate from a broker (based on comparable recent sales) to determine what you should offer for the property.