Demystifying Property Valuation: Cap Rate

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Cap Rate, commercial properties, investment,NOI, Rick BeanThere are over three dozen metrics for commercial properties that we use to evaluate assets as potential acquisitions, and to gauge their operational performance. Some are relatively intuitive: Rent/Sq. Ft., Cost per Door, Expense Ratio, Gross Income, etc. Commercial investors eschew using GRM (Gross Rent Multiplier) as that measures the income side only.

The first measurement investors look at to see if a potential investment warrants further investigation, is the Capitalization Rate Derivative, or Cap. The Cap is simply the percentage of Net Operating Income to the Purchase Price.

Cap %= Net Operating Income/Price.

As an example, an asset selling for $1,500,000 with $75,000 NOI is at a 5-Cap. ($75,000/$1,500,000 = 5%.) Understanding this ratio and its implications are key to informed investing, as well as managing operations. If you know that assets in a particular area are trading at 7-Caps you have a pretty good idea of what a property is worth if you know its NOI. Before we proceed further it’s important to clarify what NOI is.

Net Operating Income is: Ordinary Revenue – Ordinary Expenses.

The intent with NOI is to evaluate the efficiency of operations exclusive of other factors. On the income side we want to include actual rent, pet rent, late fees and other day to day items. On the expense side we want to include water, sewer, etc…the day to day operation expenses.

Exclude extraordinaryitems from NOI calcs. Examples include revenue (+) from selling timber rights, or the expense (-) of replacing a roof. These are still material when we look at a property in total…but they are not relevant in computing NOI. Also excluded from NOI are finance charges. Why? Because we use NOI to measure the effectiveness of operations. Example: A 3.87% loan with a 35-year amortization would make a poorly managed property look pretty good. Conversely, a well run property with a high interest loan might appear to be poorly operated.

I’ll discuss Net Operating Income Multipliers, the reciprocal of Cap in my next post.

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