Your Cap Rate

I did a check at LoopNet late last week to see what commercial properties are available in my area. In my search, I uncovered a 24-unit apartment complex for sale for $1,250,000. They had a proforma sheet that listed the following:

Total Annual Income ............... $179,222.00
Total Annual Operating Expenses ... $76,299.00
Net Operating Income .............. $102,923.00
Offering Price .................... $1,250,000.00
Cap Rate .......................... 8.23%

For those unfamiliar with cap rates, it's just the "Net Operating Income" divided by the price. Cap rates are another tool investors use to determine a property's worth. The higher the percentage, the better. I've heard that one should really look for properties that have a 10% (or higher) cap rate, but that doesn't mean to say that those below 10% are all bad, either. It's just another tool to use in your due diligence.

I also did some reading in several commercial message boards and through several free commercial investing articles, written by some of the leading people in the commerical investment business. One article in particular caught my attention. It was written by Ray Alcorn, who moderates the commerical message board at CREOnline.com. The article (called "What's it Worth? Deriving Your Capitalization Rate") outlines a different way to calculate the cap rate using YOUR specific criteria. Basically, the steps are as follows:

1. Determine the true NOI (Net Operating Income). The proforma, and other supporting documentation, is nice, but you should always double-check the numbers yourself to ensure you have the true NOI.
2. Determine your financing for the property. How much will your loan(s) be and at what rate and terms? How much do you plan to put down? And so on.
3. Determine the rate of return you wish to make on your investment: 10%, 20%, 30%, more?
4. Calculate YOUR cap rate.
5. Determine YOUR offer price.

Here's an example using the proforma sheet from the apartment complex above, and hypothetical data for the rest of the calculation. After doing my research, I find the figures in the proforma are accurate - i.e., the NOI is $102,923. Suppose I can only put down 10% for the purchase of the property. I can get an 80% loan @8% for 20 years, and a second 10% loan @13% for 20 years. For the 10% downpayment, I want a 20% rate of return. Using Ray Alcorn's formula, I can then arrive at a cap rate:

Cap Rate = (LTV Debt ratio * mortgage constant) +
           (LTV equity ratio * equity constant)

Since I will have two loans, my will include an additional LTV calculation. I'll need to figure the "mortgage constant" for both loans before anything else. Ray says this is done by dividiing the monthly payment of the loan by the debt service itself. Since the figure is constant, it doesn't matter what the debt service amount (and, consequently, the monthly payments) are, just as long as the interest rate and term stays the same. For the 1st loan, we can use a debt service of $10,000. The mortgage constant would be:

$10,000 @8% for 20 years
mortgage constant = monthly payment / debt service
mortgage constant = $83.64 / $10,000.00
mortgage constant = 0.083644

For the second loan, the mortgage constant would be:

$10,000 @13% for 20 years
mortgage constant = monthly payment / debt service
mortgage constant = $117.16 / $10,000.00
mortgage constant = 0.011716

Now we have all the information we need to arrive at OUR cap rate:

Cap Rate = (LTV Debt ratio1 * mortgage constant1) +
           (LTV Debt ratio2 * mortgage constant2) +
           (Equity ratio * equity constant)
Cap Rate = (0.8 * 0.083644) + (0.1 * 0.011716) + (0.1 * 0.2)
Cap Rate = 0.0669152 + 0.0011716 + 0.02
Cap Rate = 0.0880868 (or 8.81%)

Now that we gotten OUR cap rate, we can arrive at a purchase price:

Purchase Price = NOI / Our Cap Rate
Purchase Price = $102,923 / 8.81%
Purchase Price = $1,168,427

Therefore, an offer price of $1,168,427 would fit more inline with our objectives and financing. But again, Ray stresses that this is just a figure to use to aid you in your decision, and not a figure you should use to base your decision on entirely. HTH!