Cap rate for buying

How does the cap rate figure into your buying decision? Do you base whether to buy or sell based on this number? If the cap rate is lower, then the property is more expensive right? Do you have a better chance of getting a better deal when you have a higher cap rate?

Capitalization (Cap) Rate - rate of return used to derive the capital value of an income stream, divide annual income by net operating income.

Cap Rate = (Net Operating Income / Market Value) x 100


The cap rate tells you if the place is making any money.
Or Rate of Return



If I don’t see a cap rate of atleast 10 using high expense estimates I don’t even bother looking any further.

Patrick: Downtown Seattle Commercial CAP rates are running just shy of 5.5% and creeping downward, with outlying areas still around 6.5%-7%. So many of the deals I see listed at and loopnet are expecting 40%+ down, but the cash on cash return is pitiful.

You’re fortunate to be working with an area that still has decent CAP rates. I keep looking here and, being new to all of this, I know I’ll find something at some point that bears fruit.

Wow, are you able to find many using high expense estimates?

Using between 35-40% expense…a fair amount.

35-40% expenses would be a little low expense estimate. My understanding is it is better to use 45-50% total expenses.

depends on scale. But if you are looking for easy math and conservative estimates use 50%.

This is a rule of thumb that I like: Use 50% expense. 100% LTV Financing at 10% interest only. Does the property break even?

                      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.