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

Question

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.

Brian Burke · Answer

@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.

Tj Hines · Answer

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.

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!

Brian Burke · Answer

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

Bjorik Mutize · Answer

@Jordan Archer @Brian Burke hit it. You can alternate your performing and exit cap by simply changing your NOI during hold and sale.(Reduce expenses and/or Increase income through rent premiums).

Chris Grenzig · Answer

@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?

Nathan Williams · Answer

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.

David Pierce · Answer

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.

Jordan Archer · Answer

@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!

Ben Leybovich · Answer

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.

Gina Cardarella · Answer

@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

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

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