What a cap rate (capitalization rate) is and how to use it in one’s real estate investment career are two related items that I find a large number of independent multifamily investors struggle with for some reason. I’m going to answer both of these questions answering the last of the two first.

How to use cap rates in your real estate investment career
Cap rates are used to gauge the performance of an investment property. Think of a cap rate just as you would an interest rate or any other rate of return. Cap rates are driven by the desirability and perceived security of an investment. Real estate investments of course come with other considerations like the amount of effort that’s required to manage the investment and the amount of work a property will need when you acquire it.

Properties that are “safer” better quality investments that require little or no work to manage will trade at lower cap rates than properties that are perceived to require more work or that are in less proven less desirable areas. A 10 unit brick multifamily building in Brookline Massachusetts for example might trade at a high 5% cap while that same building in Lynn MA would draw offers in the 11%, 12% or even 13% cap range.

There is an inverse relationship of cap rates to value. As the cap rate goes down the relative cost or price of the asset goes up. Cap rates then are a measure of what the market says an investment is worth. It is important to note that banks use cap rates as a measure of performance.

You use cap rates in your real estate investment career to make sure whether you are buying or selling, that your expectations are in line with what the market is saying. If you are selling a 24 unit building in Dorchester Mass and you are asking a price that equates to a 7% cap and all the other buildings are trading at 9% caps you are lost. At the same time when you’re looking to buy an investment property and you find one where someone is asking for a 9.5% while the rest of the market is trading in the high 7s or low 8s you shouldn’t quibble you should buy it immediately. Cap rates express the value of the income. The cap rate equation can also be used in determining the equity value of a capital improvement you might make, but this is a discussion for another article.

Calculating Cap Rates
The cap rate equation is simple divide the Net Operating Income (NOI) by the purchase price. Buying a $100,000 NOI for $1M then equates to buying at a 10% cap rate. The devil however is in the details.

I find that independent multifamily owners more often than not misquote their cap rates. The reason this happens is that too frequently they will use incomplete numbers. The cap rate formula is subject to the GIGO (garbage in, garbage out) rule. If the numbers in the equation are not entirely complete or honest the cap rate is worthless and misleading. Savvy investors know that a lot of the cap rates that are put in front of them by independent owners are, frankly, B.S. Use this guide to start with good numbers and ensure that the cap rate you are evaluating (whether you are offering it or analyzing it for purchase) is legit.

A cap rate starts with the income. Technically speaking a cap rate starts with PRI or Potential Rental Income for the upcoming year. Most investors in our area will tell you that they don’t want to look at the potential, they want to look at the actuals. There is good reason for this. If the property has been well managed, barring any locational windfall (like a new business park or a new commuter rail stop or what-have-you ), the rents the building is currently pulling are likely all there is without making significant improvements. If there are additional sources of income like laundry, include these.

Now to the expenses, here is where most of the fudging happens. The following is a list of what is included in the expense column.

• Accounting
• Advertising
• Insurance
• Snow Removal
• Landscaping/Lawn Service
• Taxes
• Trash Removal
• Water & Sewer
• Heat (If it is included in the rent)
• Cleaning/Janitorial
• Legal
• Property Management
• Maintenance
• Repairs
• Vacancy

There are a number of these items that I find are often forgotten or intentionally omitted.

Vacancy, whether there is any or not should be calculated at whatever the accepted rate is in the area where the property resides. If you are in the Greater Boston area, use 5-6%.
Maintenance, just because a property hasn’t been properly maintained doesn’t mean that there aren’t maintenance costs associated with the property it just means they haven’t been tended to.
Property Management is often left off the list because so many people manage their own buildings. You have to include it regardless. Figure on 5-6%
Advertising whether its handled personally or it shows up in the form of a brokerage fee it exists.

After you have a legitimate list of expenses subtract this from the PRI, this is the NET. Divide the net by the ask or selling price and this is the cap rate.

Cap rates are a great way to determine the value of an investment property but they are not the only way. Cap rates may be all you ever need in your investment career but as you advance you may find out that you’re more sophisticated than the average bear and that you what you really want to know if the return or the IRR, and that is the subject of another post.