Glad you asked…
For starters, knowing the cap rate (capitalization rate) on a piece of commercial property that you may be interested in purchasing can give you a decent idea of it’s potential and of it’s potential worth or value.
Let’s go over the basics when it comes to figuring out the Cap Rate based on Net Operating Income. To do this, let’s first determine the NOI of a fictitious rental property…
This property happens to be a 20 unit apartment complex that you are looking to add to your portfolio. The fair market rental price per unit or apartment happens to be $500 per unit, giving you $10,000 per month or $120,000 annually for potential gross income. Without knowing the exact vacancy rate, let’s assume a 10% vacancy rate or 90% occupancy rate for this complex. $120,000 X 90% = $108,000 potential gross income based on 90% occupancy rate.
Let’s add other income sources that the complex may generate…like from coin operated washing machines and additional fees for parking garages…because on this complex, having a parking garage is an added amenity! Total additional income comes in at $500 per month or $6,000 annually.
Add $108,000 + $6,000 and you get $114,000 Effective Gross Income (EGI)
Now let’s figure out your expenses. We’ll include Fixed…Operating…and Reserves (which isn’t always included in pro forma documents, but is a good idea to include as a prorated expense).
Fixed- Items like property tax and insurance…etc. These items are paid for regardless of how many units are rented or not.
Operating- These items include things like property manager, utilities, advertising, lawn care, pest control, minor repairs, and such…
Reserves- Important to have money set aside for future repairs or replacements of appliances, carpet, roofs, boilers…etc.
So what does our Net Operating Income come out to?
$114,000 EGI minus $12,000 (fixed) minus $15,000 (operating) minus $2,500 (Reserves) Equals…$84,500 Net Operating Income!
So with a NOI of $84,500 we can now find out what the cap rate is on this fictitious rental property. All you need to do now is divide the NOI by the asking or sale price of the property.
Cap rate = NOI / Purchase price
This apartment complex is listed for sale at $900,000, so the cap rate is 9.4%
Another way you can look at it to determine if the property is priced fairly is take the NOI and divide it by the Cap rate to give you potential value. $84,500 divided by 9.4% equals $898,936. Now, say you are looking for properties that yield a cap rate of 9% or better. $84,500 divided by 9% target cap rate would give this property a value of $938,888. It being listed for $900,000 seems to be a fair purchase price.
Believe it or not, I’ve seen some properties with a 20%+ cap rate. These were private residence converted into entry level assisted living homes…which is a whole other posting.