How and why cap rates are used

For experienced owners, “Cap Rates” and “GRM” are common terms and most investors understand them intrinsically. However, I come across more and more buyers who are asking about how and why Cap Rates are used.

Recently I came across this question:

“How do I evaluate Capitalization Rate on an apartment building priced at $1,350,000
with gross rents of $84,000? It is newly renovated.”

The Capitalization Rate of an apartment building is used to measure its value against other assets in a similar class. The Capitalization Rate is built on the Net Operating Income which must accurately reflect the fixed expenses of an investment property.

Gross rents use to be the standard way to measure the value of an apartment building. It was a simple formulae, for example; a building priced at $1.3m with gross annual rents of $84,000, would have a GRM or Gross Rent Multiplier of 15.48. Simply use this formula:

$1,300,000 / $84,000 = 15.48 or PP / Gross rents = GRM

Sometime over the past 15-20 years, Gross Rent Multiplier got phased out and replaced with Capitalization Rate as the key form of measure for apartment buildings, and as a way to measure the actual returns generated from the purchase of a cash flowing property. To calculate the cap rate on commercial real estate you need to know the Net Operating Income or NOI. For this example we will assume the owner has a 40% expense ratio or net income of $50,400. Use this formula:

$50,400 / $1,300,000 = 3.8% or NOI / PP = Cap Rate

In the above example if the buyer purchased this building for $1.3m he would be getting an actual return on his investment of 3.8%. The capitalization rate of a $1.3m with a Net Operating Income of $50,400 is 3.8%.

Using the Capitalization Rate as a model of financial measure is a double-edge sword. Whereas Gross Rents are veritable, Cap Rates can be manipulated.

Many brokers and owners still prefer using GRM as a way to value commercial property because the numbers can be easily confirmed with a rent roll. Capitalization rates can be manipulated because expenses are subjective especially when co mingled with capital expenditures. The bottom line is that it is more difficult to corroborate Capitalization Rate than GRM. In order to corroborate Capitalization Rate you must review the past two years of profit and loss to confirm the expenses used to build the Net Operating Income.

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If you are interested in learning more about investing in apartment buildings, how capitalization rates work and why apartment buildings are such a fantastic way to build wealth, call Nick Myerhoff at 415-812-4450.