20 Unit 1B/1BA for $300,000

Net Operating Income of $52,000.

Cap Rate = 17.3%

Isn’t this a good purchase?


Is that NOI coming from a verified effective gross income and verified expenses WITH a reserve for replacement? Or is it what the seller told you?

From his P&L statement.

Are those statements audited by an independent third party?

Unaudited financial statements are not worth the paper they are printed on.

If those numbers are audited what percentage of revenue has been allocated to maintenance over the last 24 months. If it’s less than 1-2% then you’re likely in for a lot of repairs in the near future because the statements are inflated by under allocating expenses. What about the debt service payments? Are those factored in to his statements or yours because his debt service payments are irrelavent to your cash on cash return because who knows what his terms are. Check to see if he has any oustanding A/R issues with tenants and/or the payment schedules the tenants have had in the past. Accounting wise he can show A/R that is less than 120 days old on his income statement as income to be received without writing it off to inflate his net profit.

Also, compare the average rent rate per sq foot to that of the market around you. If it’s substantially higher is it because the property is very desireable or were leases signed by tenants, who when they move out, that will be replaced by lower rents more in line with the market. What is the occupancy rate, how is that compared to the market. If it’s 100% and the market is ay 92% then you should adjust the numbers more in line with the market and reduce rental income for 92% occupancy.

You almost always want to compare a property with an ‘apples to apples’ comparison to the market. 17% Cap rate is exceptionally high (8-12% being more in line with most markets) so if it sounds too good to be true, it might just be.

There are alot of ways to misrepresent a P&L.

No. The lower the cap rate the better. The rent is to low or the asking price is too high.One of this factor is not in line.

That’s entirely wrong.

The higher the rate the better.

Cap Rate is net operating income divided by sales price.

For the same sales price, the higher the income the higher the cap rate. For the same sales price, you’d ALWAYS want a higher net operating income.

The definition of cap rate per this website is:

annual income divided by net operating income

So the lower the better.

I’ve also heard it determined by:

Net operating income divided by value/sales price

The latter is more like Return on Investment

Gross income (annual income) divided by Net Operating Income = the inverse of the formula used to determine Net Profit Margin when analyzing an income statement for a business. GI / NOI has zero use here because it doesn’t help determine any information. It’s not a margin, it’s a multiplier. It’s used to determine how much you’ll have to spend to get x return (usually used to determine how much addiditional capital outlay a business will need to spend in order to generate a set net income needed to satisfy some requirement). It’s primarily helpful when determining if all variables remain the same (i.e. there are no process improvements or R&D developments within a business or industry) except captial expendatures. Since each property is independent of other properties, it has little-to-no use when comparing rental properties to one another.

And yes, Cap Rate is in many ways similar to ROI. That’s why it’s used to determine a property’s value. The value of any investement is directly proportional to ROI (it’s not equal to because you have to asses the risk, known as beta, to find the multiplier). As ROI increases, provided beta stays the same, the value increases.

A more realistic ratio to determine ROI for properties in in fact, the Cash on Cash return. Since the properties can be properly leveraged, the cash on cash return is the ROI compared to other, dissimilar investments like stocks, bonds, etc.

Sorry, about the info. Here is the correct info.

                      Cap Rate  - Capitalization Rate                                    

The Capitalization Rate or Cap Rate is a ratio used to estimate the  
value of income producing properties.  Put simply, the cap rate is the  
net operating income divided by the sales price or value of a property  
expressed as a percentage.  Investors, lenders and appraisers use the 
cap rate to estimate the purchase price for different types of  income  
producing properties.  A market cap rate is determined by evaluating  
the financial data of similar properties which have recently sold in a  
specific market.  It provides a more reliable estimate of value than a  
market Gross Rent Multiplier since the cap rate calculation utilizes  
more of a property's financial detail. The GRM calculation only  
considers a property's selling price and gross rents. The Cap Rate  
calculation incorporates a property's selling price, gross rents, non  
rental income, vacancy amount and operating expenses thus providing  
a more reliable estimate of value.   

If we have a seller and an interested buyer for particular piece of  
income property, the seller is trying to get the highest price for the  
property or sell at the lowest cap rate possible.  The buyer is trying to  
purchase the property at the lowest price possible which translates into  
a higher cap rate.  The lower the selling price the higher the cap rate.      
The higher the selling price, the lower the cap rate.  In summary, from  
an investor's or buyer's perspective, the higher the cap rate, the better. 
Investors expect a larger return when investing in high risk income  
properties.  The Cap rate may vary in different areas of a city for many  
reasons such as desirability of location, level of crime and general  
condition of an area.  You would expect lower capitalization rates in  
newer or more desirable areas of a city and higher cap rates in less  
desirable areas to compensate for the added risk.  In a real estate  
market where net operating incomes are increasing and cap rates are  
declining over time for a given type of investment property such as  
office buildings, values will be generally increasing.  If net operating  
incomes are decreasing and capitalization rates are increasing over  
time in a given market place, property values will be declining. 

If you would like to find out what the cap rate is for a particular type of  
property in a given market place, check with an appraiser or lender in  
that area.  Be aware that the frequency of sales for commercial income  
properties in a given market place may be low and reliable capitalization  
rate data may not be available.  If you are able to obtain a market cap  
rate from an appraiser or lender for the type of property you are  
evaluating, check to see if the cap rate value was determined with  
recent sales of comparable properties or if it was constructed.  When  
adequate financial data is unavailable, appraisers may construct a cap  
rate through analysis of its component parts thus reducing the credibility 
of the results.  Cap rates which are determined by evaluating the recent  
actions of buyers and sellers in a particular market place will produce  
the best market value estimate for a property.  

If you are able to obtain a market cap rate, you can then use this    
information to estimate what similar income properties should sell for.   
This will help you to gauge whether or not the asking price for a   
particular piece of property is over or under priced.  

                                               NOI                                                                   NOI 
                    Cap Rate  =     --------                        Estimated Value  =    -------------  
                                             Value                                                              Cap Rate 

Example 1:   A property has a NOI of $155,000 and the asking price  
is $1,200,000. 

                     Cap Rate =       --------------    X     100   =  12.9 rounded 

Example 2:  A property has a NOI of $120,000 and Cap Rates in the  
area for this type of property average about 12%.        

                      Estimated Market Value  =     ------------     =     $1,000,000 

Net operating income is determined by subtracting vacancy amount and 
operating expenses from a property's gross income.  Operating expenses 
include the following items: advertising, insurance, maintenance, property 
taxes, property management, repairs, supplies, utilities, etc.  Operating   
expenses do not include the following items; Improvements such as a new  
roof, personal property such as a lawn mower, mortgage payments,  
income and capital gains taxes, loan origination fees, etc. 

Appraisers use the Income Approach, Cost Replacement and Market  
Comparison methods to estimate the value of property.  The Income   
Approach utilizes the theory of Capitalization.