Clarification on how Cap Rate is calculated

[Daniel B.]

Just to clarify, is the cap rate based on the purchase price divided by the net operating income or is it the purchase price + Closing Costs + initial cost needed to get property in rental/sellable condition?

For example, if purchasing a property for $60,000 that would net $6,000 NOI (before debt payments) the cap rate would be 10%.

However, if closing costs are $3,000 (includes points) and fix up costs are $12,000 than the cap rate would be 8%

It doesn't make sense to me to not consider the fix up costs if two properties in the same neighborhood need different amounts of work/updates right away. If fix up costs are not included in the cap rate calculation, then on paper it looks like a better deal by having a higher cap rate. However, if it needs more work it will actually have a lower ROI so the cap rate would be misleading.

Thanks in advance!
Daniel

[Brian Burke]

Cap rate is such a frustrating metric. Every time I buy a Multifamily property, prospective investors in the deal will ask me, "what is the cap rate?" The best answer is, "who cares?" But that would be unsophisticated of me...

So a better answer is, "which cap rate do you want?"

- cap rate on reported trailing 12 month NOI
- cap rate on annualized trailing 90 day income minus trailing 12 month expenses (adjusted for property tax reassessment)
- cap rate on brokers pro-forma stabilized NOI
- cap rate on MY pro-forma stabilized NOI
- cap rate on after-rehab stabilized NOI using cost basis including rehab

Ugh...

Too much emphasis is placed on cap rate. The only thing that matters is return on investment.