According to the Appraisal Institute, a cap rate is the method used to convert an estimate of a single year's income expectancy into an indication of value, by dividing the income estimate by an appropriate rate. Expressed as a formula, it looks like this:
Cap Rate = NOI / Value
Where NOI = Net Operating Income. This also leads to the derivative formulae:
Value = NOI / Cap Rate, and
NOI = Value x Cap Rate
An investor is looking at a property listed at $100,000 She knows that the annual expenses will be $10,000 annually. and the income will be $20,000. The NOI is then $10,000 annually. Thus the cap rate is 10%.
A positive cash flow is hard to recognize if the cap rate falls below 10-15%. And lets face it, this is all about cash flow.
Appreciation is a great plan but most people don't have the pockets to purchase a property that will not cash flow, waiting and hoping that it will appreciate. You need income. I need income without it you call me and yell at me. Not good!
You must have the prior operating expenses for the property. More importantly they must be correct. Let us go over the numbers with you and evaluate them.
You must understand the actual operating expenses of an income producing property. Those expenses have a direct effect on the NOI, which has a direct effect on the Cap Rate. Before proceeding, let's review some terms:
- Monthly Income: The total of all revenue, such as rents, laundry, or other fees and charges (but NOT including deposits collected)
- Annual Income: Monthly Income x 12
- Monthly Operating Expenses: The total of all expenses directly related to operating the property, such as maintenance, management, repairs, utilities, taxes, pest control, advertising, etc.
but not including debt service.
- Annual Operating Expense: Monthly Operating Expense x 12
- Net Operating Income: Annual Income minus Annual Operating Expense
- Net Profit: NOI minus Debt Service
- Value: Asking price or market value of a property
For illustration, let's choose a duplex that has two 2-bedroom apartments. Let's also say that you know the current fair market rent for a 2-BR apartment in your area to be $650/month. If this property is listed at $98,000, what would be the cap rate?
You cannot answer this question unless you know the operating expenses for this property. You can figure out that the annual Income should be $15,600, but that's as far as you can go. Let's say that you are told that the owner listed operating expenses as $4,300 last year on their tax return. Now, you have something to work with (even though owners tend to inflate the actual operating expenses on tax returns, in order to reduce taxes owed.)
Using these numbers, the NOI would be $11,300, and the cap rate would be 11.53%. But, let's say that the same tax return only shows $13,700 in rental income. How does this change things? Using that figure, the cap rate would only be 9.59%.
Your investment guidelines might require a 10% or better cap rate for rental properties. How could you get the cap rate up, knowing that the owner's tax return last year shows a NOI of only $9400? If you remember the cap rate formula, you can increase the cap rate by:
- Increasing the rent (it's $1,900 a year under fair market)
- Decreasing the operating expenses ($4,300 might be too high)
- Negotiating a lower purchase price ($94,000 would be a 10% cap rate)
Don't forget to factor in your closing costs and of course my management fees.
Now, did the previous owner do all of his own maintenance? Will this make your costs higher? What about taxes and insurace? They never decrease! Did he have a high vacancy rate prior to listing the property for sale. Very common to fill a property with warm bodies that may not pay rent, just to say it's full. If so will this make your utility and trash collection higher? Don't forget eviction costs. If he filled it up with deadbeats I will have to evict them. In this area that may take 90 days.
Don't go into these things alone. Please call me. I may save you a fortune.