Help Determining Cap Rate

[Dillon Vansickle]

Hi all, 

I'm looking at a deal that's grossing $56,400 a year, with about 39% in expenses(factoring in new taxes). My NOI will be about $34,500/year. This building is in a more rural area, 30 minutes from larger cities. It's a nice/quiet area, so not low income type of rural.

With current numbers it's coming to a 5.7% cap rate(600k asking). I'm having a hard time believing the building is this valuable. It's been very well kept but rents are low and there isn't crazy demand for apartments in the area, all though it's fully leased. I'd have to estimate it's a B-/B area. 

Largest problem is there's very little comp data without going into surrounding cities that are definitely lower income, so that's not the best gauge. How can I determine an appropriate cap rate for this? I'm looking to do a value add, so I can cash out refi in few years. So having a proper cap rate will be important to determining how we can increase value. 

[Evan Polaski]

@Dillon Vansickle, first I would go to the listing broker and others, potentially from surrounding markets, to give you an idea.

Second, most sellers are crazy today in their valuations.  Granted, there is a lot of demand, sort of. But, for instance, I toured a couple 12/13 unit properties about a month or so ago.  They were about 25% overpriced, to me.  And given that both are still listed and not pending, others seem to think the same thing.  I think many sellers are "testing" waters with listed properties right now.  No real need to sell, but will if they can get their asking price, or close to it.

Third, cap rates are next to meaningless.  Even more so for a value-add play.  At the end of the day, you are looking to make a return on your money, right?  Let's say you want to net out to an 8% cash on cash return day one, grow it to 11%/yr once value-add play done, and maybe jump to 20% average annual return on exit.  The only place cap rate even enters the picture is sale projections.  And if you think 5.7% is too steep for the market, it is likely everyone else does do.  So maybe assume an exit cap at 8%, or 9%.  From there, work backwards into your purchase price to achieve that return.  

The cap rate is irrelevant to purchase price. But also, to demonstrate even more: whose NOI are you using? Is the from the T12 from seller? Is it from the annualized T3? Is it your numbers, in-place the day you take over? Is it on stabilized numbers? Let's assume the seller shows you T12 numbers, but they knew they were selling so cut their insurance from full coverage to minimum coverage, they stopped doing any repair that could be deferred, they have an in-house handyman that does all turns, and didn't book any expense to those. They stopped charging the property leasing commissions. They fired the full-time employee and just absorbed the calls with existing staff.

Most lenders will likely limit you by DSCR. So increase NOI, then you can back into a rough number on what your loan proceeds will be based on your forecast debt service upon refi.