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?