Cap rates and real estate valuation

In short

A friend of mine once bought a small duplex because the rent checks looked big. He never asked what the building cost to keep up. If you are weighing a rental property, you have probably felt that same pull toward the rent number. The cap rate is a simple way to look past it. It takes the income a property earns after its running costs and divides that by the price. The result is a percent that lets you compare one building against another. It leaves out the loan, so it shows the property itself, not the way anyone pays for it. It shows how much income a building earns for each dollar of its price.

The whole of it

What it is

I once watched an old farmer size up a field just by walking it. He did not need a spreadsheet. He asked one plain question, which was what the land would earn him in a year. The cap rate asks the very same thing of a building. Cap is short for capitalization, a fancy word for turning a year of income into a price.

The cap rate is the net operating income divided by the property's price or value. Net operating income, which people shorten to NOI, is what the building brings in after the costs of running it. It leaves out the mortgage payment. It also leaves out income tax and the cost of big repairs like a new roof.

If you are holding a listing and wondering whether the price is fair, the cap rate gives you a first yardstick. It is not the whole answer. Think of it as a quick look under the hood before the real inspection.

How it works

A friend of mine who sells commercial space likes to say the cap rate is a snapshot. It shows one year of income against one price. That is why it is so handy and also why it can fool you.

Start with the income side. Add up the rent the property can collect in a year. Subtract the rent lost to empty units, which is called vacancy. What is left is the income the building actually collects. Then take away the operating costs. These are property tax, insurance, upkeep, utilities the owner pays, and a manager if there is one. What remains is the NOI.

Then divide the NOI by the price. A higher cap rate means more income for each dollar of price. A lower cap rate means less income for each dollar, which often goes with a safer or fast growing area where buyers accept less income today. A higher number is not always better. It can signal more risk, such as a weak neighborhood or an aging building.

The same math runs backward. If you know the NOI and the cap rate that similar buildings sell at, you can estimate a value. Divide the NOI by the cap rate. That is how many appraisers and brokers form a quick opinion of worth.

The numbers, and where to find yours

You can gather most of the inputs yourself, and I would encourage you to do it. Rent comes from the leases or the rent roll, which is the owner's list of each unit and what it pays. Ask the seller for it. Property tax is public. Your county or town assessor posts the tax bill for each parcel, and the sale price and tax history are often on that same office's records.

Insurance you can price by calling an agent. Upkeep is the hard one. Owners often understate it. A careful buyer looks at several years of the seller's actual bills, not just one good year.

Do not forget what the NOI leaves out. The mortgage, the owner's own income tax, and big capital repairs are not in it. If the property is in the United States, the Internal Revenue Service explains how rental income and expenses are reported in its Publication 527, Residential Rental Property. That is a good place to learn which costs count as ordinary expenses and which must be spread over many years.

One more number matters, and it is the market cap rate. This is the rate similar buildings in the same area have sold at. A local broker or appraiser can share recent sales. No single official page lists it for your street, so ask people who watch that market.

A worked example

Let me tell you about a woman I will call Denise. She was looking at a four unit building listed at $480,000. Each unit rents for $1,200 a month. She wanted to know the cap rate before she made an offer.

Start with the rent if every unit is full. Four units at $1,200 a month is $4,800 a month. Over twelve months that is $57,600 a year.

No building stays full forever, so Denise planned for vacancy. She assumed one month of empty rent across the building each year. One month of $4,800 is $4,800. Her collected rent is $57,600 minus $4,800, which is $52,800.

Next came the operating costs. Property tax was $5,400. Insurance was $2,100. Upkeep and repairs she figured at $4,800. Water and trash that the owner pays came to $1,800. A part time manager cost $3,600. Add them up. $5,400 plus $2,100 is $7,500. Then $7,500 plus $4,800 is $12,300. Then $12,300 plus $1,800 is $14,100. Then $14,100 plus $3,600 is $17,700 in total costs.

Her NOI is $52,800 minus $17,700, which is $35,100 a year.

Now the cap rate. Divide $35,100 by the $480,000 price. That is 0.0731, or about 7.3 percent.

Denise then asked a local broker what similar buildings had sold for. The broker said they traded near 6.5 percent. Here is the backward math. Divide her $35,100 NOI by 0.065. That gives about $540,000. So at that market rate, her income would support a higher price than the one listed. That does not make it a bargain on its own. It tells her the numbers deserve a closer look, and the price is not wildly off.

Notice what she did not count. She left out her mortgage and any future roof. Those are real costs, and she kept them in mind separately.

Where it goes wrong

I have seen smart people trip on this, so be gentle with yourself if it happens. The first trap is a rosy NOI. If the seller leaves out upkeep or assumes no vacancy, the cap rate looks fine and the truth is worse. A cap rate is only as honest as the income and costs fed into it.

The second trap is comparing apples to oranges. A cap rate on an old building in a slow town is not the same kind of number as one on a new building in a growing city. Compare like with like.

The third trap is forgetting what the formula skips. Because it ignores the loan, it will not tell you whether the payment fits your budget. It also ignores future rent growth and big repairs. A building can show a pleasing cap rate and still drain a careless owner.

The fourth trap is leaning on one year. A single good year can hide a leaky roof. Look at several years of bills when you can.

The fifth is treating the result as a verdict. It is a quick measure. Do not let it be your only one.

Questions to answer before you leave this page

Have you asked the seller for the rent roll and several years of real bills, or are you leaning on one tidy page? Did you subtract a fair amount for empty units, and did you price insurance and upkeep honestly? Do you know what similar buildings in this very area have sold at, and have you asked a local broker or appraiser to share it? Have you set the loan payment, the future repairs, and your own tax situation beside the cap rate, since the cap rate leaves them out? And when you divide your NOI by the price, can you explain in plain words to a friend on your porch what that percent really says about the building?