Denominator of cap rate

23 Replies

I know that the numerator of cap rate is the net operating income.  However, I seem to see confusion on what is included on the denominator.  Is it the entire purchase price of the property including any amount financed plus closing costs plus what you estimate it will be to renovate the property?

Thank you to all who have a clear answer.

Total purchase price and costs of acquiring the property, and get it ready to start generating the numerator.  Number is the same for a cash purchase, or financed.

So the costs to rehab will have to be estimated correct?

Unless it's free money that just falls out of the sky, yes.

Originally posted by @Steve Might:

I know that the numerator of cap rate is the net operating income.  However, I seem to see confusion on what is included on the denominator.  Is it the entire purchase price of the property including any amount financed plus closing costs plus what you estimate it will be to renovate the property?

Thank you to all who have a clear answer.

You need a closed sales price and the NOI analysis that got that price from comparable properties to get a cap rate. Using your NOI against your possible purchase doesn't make any sense. How would you even use that number?

Originally posted by @Bob Bowling:

You need a closed sales price and the NOI analysis that got that price from comparable properties to get a cap rate. Using your NOI against your possible purchase doesn't make any sense. How would you even use that number?

But I thought the purpose of Cap Rate was to use as an evaluation of a possible purchase.  Are you saying it is not a useful stat?

Originally posted by @Steve Might:
Originally posted by @Bob Bowling:

You need a closed sales price and the NOI analysis that got that price from comparable properties to get a cap rate. Using your NOI against your possible purchase doesn't make any sense. How would you even use that number?

But I thought the purpose of Cap Rate was to use as an evaluation of a possible purchase.  Are you saying it is not a useful stat?

Exactly!   At least not the way you're planning to use it. It's like you got the \$ per sf of your property based on a listing price.  That tells you NOTHING useful.   Now if you know comparable properties have SOLD for \$500 a sf and yours is 1128 sf then market value is about \$564, 000.  That IS a useful metric.

Originally posted by @Bob Bowling:
Originally posted by @Bob Bowling:

Now if you know comparable properties have SOLD for \$500 a sf and yours is 1128 sf then market value is about \$564, 000.  That IS a useful metric.

Sorry, what is "sf"? The way I would use it is to enter negotiations with the seller and get his best price. I would then add my estimate of costs to repair the building. That would be the denominator of the ratio. Next I would get his paid rents, tax returns, utility bills etc., and come up with an estimated NOI for the numerator. Yes?

Originally posted by @Steve Might:
Originally posted by @Bob Bowling:
Originally posted by @Bob Bowling:

Now if you know comparable properties have SOLD for \$500 a sf and yours is 1128 sf then market value is about \$564, 000.  That IS a useful metric.

Sorry, what is "sf"?  The way I would use it is to enter negotiations with the seller and get his best price.   Yes?

Um, no.  First sf is square foot.

Second, let's say you do all your figgering and guesstimates on a faux cap rate. Let's say you divide your NOI by YOUR made up purchase price + whatever you want to incorrectly add to it and let's say you come out with 10% crap rate. Whee! That's almost 10 times more than I can make at the Bank. So now to the negotiating with the seller and you pressure him to a lower than your made up purchase price and now you're getting the property at a 11% crap rate. You'll be rich soon.

Of course the seller knows about cap rates and knows the market cap rates are about 14%!! So for every \$10,000 in NOI you overpaid about \$19,500. One born every minute.

Is this what you had in mind?

Ex. NOI \$10000/ your made up crap rate of 11%= \$90,909 purchase price.

Seller \$10,000 NOI/Market cap rate comps of 14%=\$71,428 MARKET VALUE.

Your great purchase price \$90,909- Market value of \$71,428= \$19,481 in EXTRA profit to the SELLER for each \$10,000 in NOI by selling to unsophisticated buyers. That's how you make money in real estate!!!

Originally posted by @Bob Bowling:

Is this what you had in mind?

No, of coarse not. So how or what do you use to evaluate a prospective purchase?  Do you ignore Cap rate during pre purchase?

Originally posted by @Steve Might:

Originally posted by @Bob Bowling:

Is this what you had in mind?

No, of coarse not. So how or what do you use to evaluate a prospective purchase?  Do you ignore Cap rate during pre purchase?

What type of property for what length of holding period in what market?

Originally posted by @Bob Bowling:

What type of property for what length of holding period in what market?

I just want a general template.  I look at single family houses and multi-family.   Lately I have been very interested in the multi-family units where I can get good cahsflow

I appreciate Bob's help, but I would like to know if everyone else agrees with him.

From reading @Bob Bowling 's other posts, he would probably say that cap rates are not useful for SFRs or small multifamilies.  The main reason being that accurate expenses are so difficult to obtain for small buildings.

Other ways of estimating price to compare your building to the market (both sold and for sale) could be:

1) using price per sq ft (more common for single family)

2) using the gross rent multiplier

3) doing a simple price-per-unit comparison

None of these take into account expenses, so there is one fewer variable to account for.  However, you will still have to know expenses on your property to see if your cash-on-cash return will meet your goals.

Cap Rate and  Appreciation are the two most over hyped terms in Real Estate.

According to me what matters is

1> COC ( Cash-On-Cash) ,

2> Annual Returns and

3> GRM ( Gross Rent Multiplier).

You could have a 5 cap rate and when you put the numbers together and slice the pie, you may realize that it does not provide 12 - 15% investor return or you have to sacrifice a lot of your equity to meet those returns, in which case its better to not do the deal and walk away.

GRM is a more valuable apples to apples comparison which will justify your offer price more in line with reality than speculation.

Hope this helps.

Why not base your sale price on cashflow? NOI and x% rule are nice but they are all approximations to test your assumptions but in the end, your requirements and what you bring to the table are different than everyone else.

Figure out what you want for an annual vacancy rate... say 5%. then compute your income. With your income in place, compute how much you can afford with the available down payment and loan price?

Personally, I put it into a spreadsheet for myself and I think Bigger Pockets also has a spreadsheet that lets you do something like that. For me, I do the calculations the normal way (price + estimated repairs + expenses) then compare those to what the rent rates are based on the what the owner / realtor state and do a second set of calc based on what I think the expenses would be (then take the larger of the values for the expenses) and also figure out what I think the rents would be based on various sources.

Finally... find a price that gives me the right level of profits that I am looking for... working down from the sale price. With Excel recalcing really instantly makes this easy. Finally... Hit Zillow and other sites to see what other homes in the area are selling for so you don't go to far over the price similar homes in the similar areas. Based on all that, figure out what the most you want to spend on the property is and don't go over it.

Personally, I love numbers and love trying to figure out how to do a lot of these calcs but in the end, you need to figure out how you want to profit from the sale and then calc your value proposition. Finally... negociate.

Take everything i said with a grain of salt... other than buying my home and just buying my first investment property (but putting over 40 under analysis before putting offers in on 4 and winning 1) so, I may be missing something but I trust the numbers so I will see how I do compared to my estimates late next year.

Mark Forest

The thing about CAP rates is they are easily and frequently misused.

CAP rates are only useful to compare the cost of cash-flows in a local market, and then only if each CAP is calculated using the same method {you and I could calculate the CAP for a given building and get different results}. Finally the CAP does not tell you anything about the quality of a cash-flow, just its cost relative to its peers.

So if you had a 100-unit property in Manhattan with a CAP of 5% in might be delightful, but one in Toledo with a CAP of 5% probably is not .... furthermore, using CAP to compare these two properties is dangerously meaningless.

Similarly, CAP would not be a useful metric to compare a quadraplex with a 50-unit apartment as the nature (quality) of the cash-flows would be substantially different.

Originally posted by @Steve Might:

I am surprised cap rate is not favored here.  After seeing this post http://www.biggerpockets.com/renewsblog/2010/06/30... I thought CR was standard.

They are used mostly for 5+ unit multifamily, not SFH or duplex/fourplex - because of everyone using different numbers. That's why I think GRM is more reliable on 2-4. 2-4 unit appraisals generally use the price point, not the income to drive the pricing, at least in CA..

Experience: I have reviewed commercial & residential loans and appraisals at dozens of banks in my 9-5 job.

I have a question, what's with @Bob Bowling's attitude?

@Steve Might politely asked a question, which the forums are for, after all.

Originally posted by @Zach Chappell :

I have a question, what's with @Bob Bowling's attitude?

It would help if you were clearer about what you perceive as attitude and describe that attitude (good, bad, cheerful).  Then I could clearly and cheerfully answer your question as I did for the OP.

@Bob Bowling, how would you describe your tone in the following post?:

"Second, let's say you do all your figgering and guesstimates on a faux cap rate. Let's say you divide your NOI by YOUR made up purchase price + whatever you want to incorrectly add to it and let's say you come out with 10% crap rate. Whee! That's almost 10 times more than I can make at the Bank. So now to the negotiating with the seller and you pressure him to a lower than your made up purchase price and now you're getting the property at a 11% crap rate. You'll be rich soon.

Of course the seller knows about cap rates and knows the market cap rates are about 14%!! So for every \$10,000 in NOI you overpaid about \$19,500. One born every minute."

I consider the cap rate as the % return on my investment for my time, money and headaches. I apply the cap rate as 1 tool to help find my acceptable purchase price in 5+ unit multi's. I won't be buying anything for a 5% cap rate in any area, as I can buy paper securities that return more than that without tenants & toilets. To find my acceptable purchase price with the income approach to value I simply divide the NOI by my necessary return of 10% for decent property, up to 14%+ for older properties with deferred maintenance issues or in tougher areas. An example would be annual NOI of \$32,000/.1 = purchase price of \$320,000. But that's just one ratio. As it's been said, we need also to get comps, look at the GRM, COC, debt service coverage/break-even analysis and cost to build. If you are willing to accept a lower return, divide the NOI by that. It's a quick analysis to see if you want to pursue the property any further.

Originally posted by @Zach Chappell :

@Bob Bowling, how would you describe your tone in the following post?:

FACTUAL, as proven once again by the post above.

Join the Largest Real Estate Investing Community

Basic membership is free, forever.

By signing up, you indicate that you agree to the BiggerPockets Terms & Conditions.