How much should emphasis should you put the cap rate included in a listing when evaulating a deal?

From my understanding the higher the cap rate the more risk there is with the property and bigger potential for returns. However the cap rate shown in a listing is based the current NOI and listed sale price. How do you figure the actual cap rate, or projected cap rate? I'm looking at a property with a cap rate of 4.5, that has rents with room to increase. Does that mean my cap rate is higher?
In Buying Property - Asked by Jim H. - Jul 7, 2010
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Answer(s)

Ben R.
Lender/Mortgage Broker
Riverview, FL

Cap rates are an absolute neccesity for determining true property value. CB Richard Ellis has a cap rate chart that gives reasonable rates for particular areas. Go to http://www.prestprop.com/docs/MarketView_Apr09.pdf and view them there. They break down cap rates according to property type and class. a 10% cap may be average for a "C" class apartment but not an "A" class apartment. The older the building, the higher the cap rate, the higher the risk. You should purchase at high cap rates and sell at lower cap rates. To figure out cap rate on a listing just divide NOI by asking price. I would then check CB Richard Ellis's cap rate chart to see where you are according to thier information. If the 4.5 cap property you're looking at is a "C" class property, it must be highly distressed and/or vacant. I would used the current NOI of property (NOT proforma) and divide by current CBRE cap rate for that type of property and make an offer based on that number minus repair or rehab cost and -5% acquisition cost.

Jul 7, 2010
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John B.
Broker/Agent
York, PA

Jim,
The Cap Rate is the Cap Rate. Certainly you can speculate that the NOI or market value may go up or down, but is does not change what the Cap Rate for that property is today. It sounds like you have a pro forma calculation that addresses the upside you see in the property. Until that upside is realized, the Cap Rate does not change. As far as how much emphasis to place on today’s Cap Rate and your pro forma Cap Rate, that is a function of risk and how confident you are in achieving your upside. In the immortal words of Dirty Harry, “you've got to ask yourself one question: Do I feel lucky?” Well, do ya, Jim?

Jul 7, 2010
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Thomas E. A.
Broker/Agent
Lake Havasu City, AZ

Jim: Just because a cap rate is higher, does not necessarily mean more risk - although this is many time the case. It may also mean more involvement in the property or business. For example, if you were to buy a Walgreens with no landlord responsibilites, just the receipt of rent, then the cap rate would be low (maybe 7-8%) - a reflection of the landlord duties and the credit-worthiness of the tenant, Walgreens. On the other hand, if you bought a convenience store property with a non-national tenant, you should expect a much higher cap rate, say 10-15%, for the risk invloved there. What is the credit-worthiness of this tenant?
The actual cap rate is figured by dividing the NOI by the purchase price. The cap rate is only one way to view a property. There are many methods that people use. For example, with multi-family property, many people use a rent multiplier.
Cap rate is important, but you need to look deeper into a property before a decision can be made. Just getting to the real NOI can be a challange - are there reserves in the NOI?, etc. Right now, almost anything with a cap rate of 4.5 is not saleable - this is much too low. Even if there is room to move the rents up, why has the current owner not done that? Almost all properties are sold today on present numbers, not future.

Jul 8, 2010
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Tyler J.
Broker/Agent
Portland, OR

Jim,
Be careful on when looking at the Cap Rate listed on LoopNet or just about any website for that matter. A Cap rate is very easy to manipulate by lowering the expenses or increasing the income. Most commonly a broker will do one or the other to increase the likelihood of selling the property. This is very common in the industry and unfortunately a lot of time is wasted looking at 8 Caps that turn out to be actual 6 Caps.
Request from the broker a current rent roll and the opertating expenses for the last 12-24 months to give yourself a better idea of the true NOI (net operating income). Be careful that the words "Proforma" are not listed on any of the statements. A lot of the marketing packages and flyers will show a proforma Cap Rate and not until you are in escrow will you discover that the actual is much worse.
You are sort of right about the risk factor, in general a low cap rate should be a lower risk investment, however keep in mind a very expensive property will also have a low Cap rate. For example, a 10 unit class D apartment building that is half vacant and in a bad area of town could be listed for a 4% cap rate.
As for the upside in the rents, make sure that you are comparing similar properties and similar units to determine the rental upside. Do not base the "upside" on the rents in a marketing package, this is another area that is easy for a broker to manipulate.
Parting advice is to use a broker specializing in the product and area which you are looking to purchase.

Jul 8, 2010
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David C.
Los Angeles, CA

Commercial Real Estate is all about the ratios.
A ratio is a relationship between a balance sheet or income statement value.
The most commonly used ratio in the commercial real estate market is the CAP Rate, which compares the annual income of a property by the net operating expenses to get the CAP Rate.
Use the Analyzer on my website generate ratios for all your prospective commercial real estate purchases.

Aug 23, 2010
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Richard B.
Owner/Investor
Savannah, GA

Remember when buying- the higher cap or no cap the better- ( depending on what your strategy is).
When selling or refinancing- the lower the cap the better.
Higher caps are usually higher risk but if you can look with vision at property- the value add philosophy- you might have a great deal!!!!
Hope this helps and good luck!!!!
Richard B.

Nov 12, 2013
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