Cap rates are what determine commercial building valuations. All sophisticated investors look at cap rate, even if they do not know what it means. Some Realtors like to hide expenses, and not calculate them to get higher selling prices and higher cap rates.
This post will help you understand how commercial investors use cap rate to evaluate a building. It can also be used as a basis for a residential rental.
Cap rate is based on the amount of gross income that is generated. Gross operating income, is income (rents, laundry, fixed fees, etc.) less the expenses (taxes, utilities, dues, vacancy expense, management fees, etc.). A typical 4-plex might have $1,000 x 4 x 12 in annual income, or $48,000.
A typical industry standard expense ratio is 45% of rents allocated to expenses. That would include taxes, dues, maintenance, vacancy and management expense. If you are higher, you need to look at how much you are spending, or look at the rents you are bringing in. Many expenses are static or “hard”, they cannot be adjusted down, Association dues, taxes, and utilities are all constant. 45% of $48,000 is $21,600 in expenses and $26,400 in gross operating income.
Other expenses such as maintenance, vacancy and management fees are less firm, especially if you manage the building yourself. Either way, the “soft” expenses still need to be figured in. Many investors and Realtors make this mistake. If the soft expenses are not provided, use 10% of rents for maintenance, 8% for management and 5% for vacancy. That means your hard expenses cannot exceed 22% of rents.
Calculating a Cap Rate is simply the gross operating income, divided by purchase price. Purchase price (i.e. selling price) can be also computed if a desired cap rate is known.
Often, in great real estate markets, a 6% cap rate is not uncommon for quality class ‘A’ properties. A 12% cap rate is a sky-high rate, or is in downtrodden neighborhoods. 8% to 10% might be about average for an average apartment. It also depends on the neighborhood or apartment classification.
With $26,400 in gross operating income, and an 8% cap rate, the building valuation should be about $330,000. If you take in $50 less each month per unit, or only $2,400 less per year, the building valuation goes down to $313,500 with the same 8% cap rate. Take in $200 less per unit, or $800, and your building valuation is only $264,000. Bring in subpar renters, and your rents and valuation suffers. The only way someone will pay more, is if they are naive, or plan on upgrading the unit.
It makes financial sense to get higher rents, not only from a profit standpoint, but a building valuation standpoint. Even a $25 per month improvement makes a big difference in building valuations and profitability. Every $25 improvement that is made in average rent in a 4-plex, at an 8% cap rate, brings the building value up by $8,250. You cannot get sky-high rents from sub-par renters. The sub-par renters might sign a lease, but you will not collect.
Have you ever used cap rate to evaluate a rental purchase? Of any other analysis on some other investment?
Never heard of cap rates before. Good explanation.
Thanks Deb. It’s a bit confusing at times, but cap Rate is what all commercial properties are quoted at. Sometimes, selling agents under-estimate expenses, or over estimate revenues, to get a higher valuation.
I purchased ten properties at an average of 40K including repairs..(385,000K+15k taxes)..(approx. one year from purchase to fully rented (from class c to d) each property brings me on average of 1460 per month (sec-8)…….1460x9x12=157680x.45 (rents vary upon conditions, utility cost…etc….3-6bed is 1200 – 2000$)
=86,724ROI / 400k(cost) =.21×100 = 21% …..is this normal?…lol….i deducted one unit because my building manager lives in a two flat which he rents to pay utilities ….properties are not located in the most desirable neighborhood…..i advertised the postion and interviewed about five potential managers……backround checks a must!!!!……be fair with the people that make you money…….my manager gets many benefits…..i will probably give him the deed to the house he lives in!….after all is said and done heopfully in ten years these properties will increase 5-fold……in the boom years the properties i hold, not one sold for less than 100k the most being 480k….i know its ridiculous….
*only problem is…these properties are only worth what i have put into them on average too…which sucks…..after four years!!!
** I am also a contractor….average house cost by labor/work….
I DO A LOT OF WORK MYSELF…..SO MAYBE 5k in labor savings per home…..
Architect….$2000…..usually cheaper
Permit…$500…varies about average
Dumpsters…..1-2 30 yard….about $1000 sometimes none
siding / masonry…varies ….usually 2-4K and always about the max amount
Roof….varies …usually few hundred – 3k
Windows………..usually…1500
Frame/drywall/insulation…..varies…usually..3k
elec/plumb and fixtures………usually ……6k
hvac…usually $5000…gerber ac and furnace….
floor/tile….pvc/ceramic…no more than $1.25 for material (tile.grout.mortar) $2.5 labor….1000k
paint…..usually 1500 per house with material…nothing special….primer/paint all walls and trim same
trim……usually mdf unless i can find used pine cheap…or sometimes none…some doors repairs.
applicances….usually used…1000k
cabinetry/formica counters/mirrors….2000k
landscape cleanup…….1000
etc…..door hardware……some other minor stuff ….some cost less some more…so about 400 k for ten houses…….start collecting kitchen cabinets and plumbing fixtures…..You will need them the most!!!…..
all homes located in the chicago city limits too!! i try to go east of the expressway, but good luck trying to find something descent in 2014!!!!!!….all of these properties purchased before 2010….at amazing prices…..
****advice…….be cheap in these areas….mdf vs pine; laminate vs. granite……..as one contractor told me here in Chicago “This is not the north side”….
i also own a few building in some more ritzy areas of chicago….the cap rate is shit….compared to the ghetto…but i manage these myself and one is my owner occupied building….
Thank you for the comment!
Just curious. “hopefully in ten years these properties will increase 5-fold”. How do you expect that, if “these properties are only worth what i have put into them on average too…which sucks…..after four years!!!” Do not look for too much of an increase. Read this post.
If you are in a low income area, you definitely need to go cheap as you need to keep your expenses down. Your maintenance expenses will be higher than most other areas. I don’t use MDF though, just pine. It’s better if it gets wet.
A 21% ROI is great, but you may need it for a Class D area. Much less than that, and it’s hard to make money. I have see people think that an 8% return in those area is enough, and they eventually lose big.
Thanks for the explanation…I’ve been seeing “cap rates” a lot lately as I’ve been reading more and more blogs related to investing in real estate. I’ve been meaning to do some research on it so this was very timely.
It will be crucial when you invest in multifamily properties, but is also applicable to all properties. It helps you understand what your return is, so you can compare it to other investments. Remember, RE is higher risk.
What is the cap rate that one should look for when investing. I have seen properties with more 12% as cap rate does that mean something’s wrong.
I wanted to know are all your properties under llc. Would you advise that to your readers.
Which accounting or property management software do you use?
12% cap rate is great, but often they are in a category D neighborhood. Or the Seller didn’t add in all of their costs. Assume 45-50% of rents for expenses.
I use Quicken for my accounting software. I have all my rentals in their own LLC, and I have a LLC as a holding company. And I have an S-corp that manages all of the property.
I have each property in their own separate LLC. Do you have yours all in one? May I ask what is the purpose of the holding company?
Each property being in a LLC, and an LLC as a holding company. That way, the holding LLC can conduct business for all of the separate LLCs. An accountant told me to do that. My income/expenses are passed down to my holding company from my S-Corp. The S-Corp manages the properties. The holding company then allocates the income/expense amounts to each sub-LLC.
Wonderfully simple explanation. There is an apartment building that just went up for sale near us. I don’t think we are in play at this time, but it would be interesting to run the numbers. I suspect it is full of sub-par tenants.
That is the way I started. Taking random apartments and running the numbers. Assume 15% of rents are going to be used for expenses. Taking an apartment full of subpar tenants, and upgrading it to a better class of tenants, is a prime way to build equity.