Cap rates and commercial property valuation

In short

A friend of mine once bought a small building because the seller said it paid "a nine percent return," and he never asked how that nine was figured. If you are looking at a rental building, the cap rate is the first number you will hear, and it is worth knowing what sits behind it. The cap rate is one year of net operating income divided by the price of the property. Net operating income is the rent that is left after the running costs of the building, before any loan payments or income tax. A higher cap rate means more yearly income for each dollar of price, but it can also point to more risk. A lower cap rate means a pricier building, or a steadier one. Write down the seller's income and costs yourself, and then divide.

The whole of it

What it is

I once watched an old farmer size up a field by asking what it grew, not what the sign said. The cap rate asks the same plain question of a building. How much does it earn in a year, compared to what it costs to own? The word cap is short for capitalization, which is just the habit of turning a stream of yearly income into a single price.

The formula is short. Cap rate equals net operating income divided by property value. Net operating income, often called NOI, is what the building brings in from rent and other fees, minus what it costs to run. Those running costs include property taxes, insurance, repairs, upkeep, management, and the cost of a vacant unit sitting empty.

Notice what is left out. Loan payments are not counted. Income tax is not counted. Big one time repairs, like a new roof, are usually handled apart from the yearly figure. That is on purpose. The cap rate is meant to describe the building itself, no matter who owns it or how they paid for it. Two buyers with very different loans can still compare the same building on equal footing.

You can also turn the formula around. If a building earns a known NOI and buyers in that area expect a certain cap rate, then value equals NOI divided by cap rate. This is how many appraisers and brokers reach a price. Same math, other direction.

How it works

You have probably heard someone say a market is "pricing at a six cap." That just means buyers in that spot are paying about sixteen and a half dollars of price for each dollar of yearly NOI. Divide $1 by 0.06 and you get about $16.67.

Here is the part that trips folks up. The cap rate is a reading, not a promise. A low cap rate usually tells you buyers are confident about the building or the neighborhood and are willing to pay more for each dollar of income. A high cap rate often tells you the income looks less certain, or the area is less in demand, or the building needs work. Neither one is good or bad by itself. It is a price tag on risk, and you get to decide how much risk suits you.

The rent side deserves a careful look. Sellers often show the income a building could earn if every unit were full and every tenant paid on time. Your own figure should rest on what the building actually collects. Ask for the real rent roll, the list of each unit, each tenant, and each rent. Ask for the past twelve months of bank deposits to match it. A kind but firm request for records is not rude. Most honest sellers expect it.

The cost side needs the same care. Sellers sometimes leave out management fees because the owner runs the place alone. But your time has value, and a future owner may hire a manager. Likewise, repairs in a year with no trouble can look cheap. A fair estimate includes a yearly set aside for the roof, the boiler, and the parking lot, even if none of them failed this year. Costs always come due.

The numbers, and where to find yours

You will want three numbers. The first is gross income, which is the rent actually collected plus any other fees such as parking or laundry. The second is the full list of yearly operating costs. The third is the price, whether it is the asking price or the price you are thinking of offering.

Where do you find them? The seller or broker should hand over a rent roll and an operating statement. Ask for the last two or three years if they exist. Property taxes are public record, and your county assessor or tax collector keeps the bill and the assessed value on file. Do not just copy the seller's tax number. A sale can trigger a new assessment in some places, so the bill after you buy may differ from the bill before. Ask the local assessor's office how a sale is handled there.

For insurance, call an agent and get a real quote on the actual building. For market cap rates, look at what similar buildings in the same area recently sold for, along with their income. A local commercial broker or appraiser can share sale comparisons, and some brokers publish market reports. Treat any one report as a rough guide and not a rule. Cap rates change from city to city, from block to block, and from year to year, so this page gives no single figure for what a good one is.

One more source worth knowing is the lender. A bank looking at a commercial loan will run its own numbers on income and costs. Its view of the NOI can be a useful check on yours.

A worked example

Let me tell you about a woman named Marcy. She found a small four unit apartment building listed at $600,000. The broker said it was a great deal. Marcy, being careful, asked for the papers instead of the pitch.

Each unit rented for $1,250 a month. Four units at $1,250 a month is $5,000 a month. Over twelve months, that is $60,000 a year if every unit stays full. The bank deposits showed one unit sat empty for two months last year. Two months at $1,250 is $2,500 of lost rent. So rent actually collected was $60,000 minus $2,500, which is $57,500.

Now the costs. Property taxes came to $7,200. Insurance was $2,400. Water and trash, paid by the owner, ran $3,000. Repairs and upkeep averaged $4,000. The seller managed it alone and charged nothing, but Marcy figured a manager would cost 8 percent of collected rent. Eight percent of $57,500 is $4,600. She also set aside $2,000 a year for big items like the roof.

Add the costs. $7,200 plus $2,400 is $9,600. Add $3,000 and you reach $12,600. Add $4,000 and you reach $16,600. Add $4,600 and you reach $21,200. Add $2,000 and the total is $23,200.

Net operating income is $57,500 minus $23,200, which is $34,300.

Now divide by the price. $34,300 divided by $600,000 is about 0.0572, or a cap rate near 5.7 percent.

The broker had quoted a number closer to 7 percent. How? He used full rent of $60,000, left out the manager and the set aside, and trimmed repairs. His income was about $60,000 minus $16,600, which is $43,400. Divide $43,400 by $600,000 and you get about 7.2 percent.

Same building. Two honest looking answers. Marcy now knew exactly which costs were in play, and she could talk to the seller about price with facts in hand. She was not angry, and she did not need to be. She simply asked questions and did the sums.

Where it goes wrong

I have noticed that the simplest tools get misused the most. The cap rate fits on a napkin, so people trust it more than it deserves.

The first trap is the one Marcy avoided, which is a flattering NOI. Full rent instead of collected rent, missing costs, and skipped reserves can all lift the number on paper. The cap rate is only as good as the income and costs fed into it.

The second trap is forgetting that it looks at one year. A building with leases ending soon, or rents well below the market, or a roof near the end of its life, has a story that one year of NOI will not tell. The cap rate says nothing about how income might grow or shrink.

The third trap is ignoring the loan. Because the formula leaves out financing, a building with a 6 percent cap rate does not mean a 6 percent return to a borrower. The borrower has to repay the loan with interest, and that changes what the owner actually keeps. The cap rate and the cost of the loan are two separate conversations.

The fourth trap is comparing unlike buildings. A cap rate on a shop with one long lease to a stable tenant is not the same animal as a cap rate on an older apartment house. Compare like with like, in the same area, of similar age and condition.

And the last one is plain old rushing. Sellers and brokers sometimes press for a quick answer. A fair deal will still be fair after you check the numbers.

Questions to answer before you leave this page

Can you list every unit and the rent it truly collected over the last twelve months, not just the rent on the lease? Have you put in every cost, including property taxes, insurance, repairs, a manager, and a yearly set aside for big items? Did you check how the county assessor handles taxes after a sale, so the bill you use is the bill you will really get? Have you divided your own NOI by the price, and does it match the seller's number or differ from it? If it differs, do you know exactly which line explains the gap? What do recent sales of similar buildings nearby suggest about the going cap rate, and who could help you read that data? And finally, have you kept the loan in its own separate box, so you do not mistake the cap rate for what you would actually take home?