What's the market standard for calculating the cap rate?

17 Replies

What is the market standard for determining a property's Cap rate and NOI? Do you get a professional appraiser or is it just as off the cuff as it appears to be on Loopnet?

Are their certain expense items you can leave out, or is it very important to keep strict accounting records? 

If I buy a property where the market cap rate is 5% and I get it to a 6%, then I know I've added value. However, the accounting standard seems to be vague for how the market cap was determined. 

@Jordan Archer The standard is dependent on who's presenting the info. Sales people (brokers, agents, seller) can and will present you the most aggressive set of #s (say T3 NOI or T1 NOI) whereas investor might use something else.

Where you bring the cap rate has little bearing on what the market is going to pay. Also, as an owner you want your property yielding the highest cap rate but as a seller you want to sell for the lowest cap rate.

@Jordan Archer the standard for determining cap rate is to take the annualized trailing gross income (typically annualized T3) minus tax-adjusted expenses (to arrive at an NOI), and then dividing that result by the property's purchase/sale price.

"Tax adjusted" means that you substitute the property taxes that the new owner will pay for the property taxes that the seller was paying (in many states those numbers can be drastically different).  Expenses include only operating costs. Capital improvements, debt service, and partnership-level expenses don't count.

To your point about buying where the market cap is 5% and you "get it to a 6%," that's not possible. You could buy it at a 6% cap rate, but you can't move the cap rate. Cap rate is NOI divided by purchase price--it is what it is and the only way to change it is to change the purchase price (because you can't change the trailing NOI). I think what you are trying to articulate here is actually yield on cost, which is different than cap rate.

Yield on cost is where you divide the NOI by your total cost for the property, including closing costs, the cost of any renovations, and sponsor fees (if syndicated). If your YoC is 6% and the market cap is 5% you have added value to the tune of 20%. People often make the mistake of misusing cap rate in this scenario, taking their NOI after a renovation divided by their purchase price to demonstrate the value that they've added--but that doesn't work because it doesn't account for what was spent to get the property to that future condition.

CAP rate is simply a valuation metric used by investors to determine yield.

The buyers set the CAP rates in any given market for the different types and classes of real estate.

Asking prices are irrelevant. A property is only worth what someone is willing to pay. If a property is highly sought after it may trade well below the average CAP rates in the market. The converse is also true.

It’s all about supply and demand.

Originally posted by @Bryan Mitchell :

@Brian Burke, don’t you still need to take into consideration current market rates and possibly future market conditions?

Only as it relates to predicting market cap rates at the time that you plan to measure your yield on cost. 

@Brian Burke

Thanks for your response. You helped answer some of my question by saying that Cap Ex isn't considered an operating expense when determining NOI.

When I said "raise the cap rate," I mean raising the NOI by bringing rents up to current market rent (then comparing that to your original purchase).

@Omar Khan

Yes I know what you mean about brokers advertising the most aggressive numbers. 

What is the market standard for determining a property's Cap rate and NOI(Using the simple formula NOI/Sales Price will give you the cap rate. Also, understand at what cap rate are properties similar to yours are trading for is important as well. Not to mention you should also have a good idea of understanding how much properties are trading for per door similar to yours in the area)

Do you get a professional appraiser or is it just as off the cuff as it appears to be on Loopnet? (You need to attain the most accurate financials you can from the seller or broker. Starting with a T12 and most recent rent roll should get you started to understanding the real actual value, not the proforma the broker or seller is pushing the property for)

Are their certain expense items you can leave out, or is it very important to keep strict accounting records? (You need to take into account every single expense this property has. Leaving things out can throw the perceived value off, as well as your projections)

Good luck!

@Jordan Archer

I'm fairly new to being an investor only starting now to look for my 2nd building however to me I start to look at the rents do all the math and then allow for some errors that don't exist and check the rental market as well and the surrounding properties

@Brian Burke

I prefer to look at the now and the past what it has been with room to improve then if future rents and value goes up which it does if you can hold on long enough that's "cherry" To me you will have a little more room on your investment ex: bit more maintenance bigger cap ex came sooner then predicted you still have Room in your investment but that's just me

Originally posted by @Jordan Archer :

What is the market standard for determining a property's Cap rate and NOI? Do you get a professional appraiser or is it just as off the cuff as it appears to be on Loopnet?

Are their certain expense items you can leave out, or is it very important to keep strict accounting records? 

If I buy a property where the market cap rate is 5% and I get it to a 6%, then I know I've added value. However, the accounting standard seems to be vague for how the market cap was determined. 

The accounting standards are somewhat loose. Congratulations - you've caught onto the biggest dirty secret in RE lol. Whether CapEx is below the line or above depends on your buyer. CCIM has an opinion, and so does CBRE. @Brian Burke has an opinion on everything, though it's not clear whether he knows anything at all :)

In this conversation, there is a lot of gray areas. Everyone knows the formulas. Not too many people know the application of said formulas. 

Whenever there is an opinion, I invite you to consider the motives. This will allow you to glean into the application.

@Ben Leybovich

Though we've never had a conversation, you always make me laugh.

I know you're big in syndication. Do you have any tips on raising capital? I'm planning on going to an IRA symposium in Orlando soon to rub elbows with IRA holders.

Thanks!

Cap rate is a just the return on investment on normal investment property. Industry standard investment property. No deferred maintenance, etc. It should always be based on the last 12 months NOI assuming the tenant stays in place and no underlying expense factors are on the horizon - or in the past. (A new roof is not technically an expense. It is a planned further investment, etc.) It is just a rule of thumb. But in coming up with your IRR the cap rate buy and sell should stay constant. Assuming it is not a redevelopment, change of use, etc.

this is one of my pet peeves about cap rate.  There never seemed to be any uniformity with how its measured.  For example Ive seen some factor in stuff like repair and vacancy rate while others dont.  So when I see people throw out cap rate %s without the details I just treat it as a preliminary measurement.

As a out of state investor who is looking at markets throughout the USA my most valuable numbers comes from my own internal calculations that I can keep consistent across the board.  

@Jordan Archer I'm somewhat happy you asked this question because I think it helps illustrate how subjective cap rates are. 

We frequently buy properties that are 8% cap rates on "financials" but 5% cap rates on our year 1 expenses. Thats because the taxes go up, or needs better landscaping, or needs more payroll, better insurance, etc.

Conversely, we'll buy 5 caps on in place and they'll be 5.75% cap on year 1 proforma, same reasons but the opposite (minus taxes).

Also, you'll see deals being sold as a 6 cap tax adjusted, but they took all the T-12 expenses and adjusted them to "market".

I've also seen deals that run their R&M at like $80 a door when market is like $400-500, but their below the line Capex is $1000 a unit. So whats the cap rate for that deal?