Cap Rates: What is your NOI?

Cap Rates: What is your NOI?

If you have spent any time buying or selling commercial real estate, you’ve probably heard (or said): “I am a buyer at a [fill in the number] cap rate or higher.” But what does that mean? As we discussed previously, a cap rate is a basic method of evaluating risk and return. Real estate acquisition is as much an art as it is a science.

Multiple investors can look at the same property, the same historical financials, and calculate different values for the same cap rate. Depending on the property and the investor’s business, we could be looking at historical cap rates, pro forma year one cap rates, or possibly the stabilized future cap rate.

Caveats and Limitations

There are several variables and factors that change the way we look at numbers in real estate. For the purposes of this discussion we will not be making any assumptions about: market cap rates, cap rate movement, debt, replacement cost, price per unit/square foot, comparables or highest and best use.

Analysis

Broker Trailing 12 Trailing 6
Gross Potential Revenue $1,000,000 $950,000 $975,000
Vacancy 5% ($50,000) 7% ($66,500) 6% ($58,500)
Net Rental Income $950,000 $883,500 $916,500
Total Expenses ($450,000) ($400,000) ($425,000)
Net Operating Income $500,000 $483,500 $491,500
Price / Valuation 7% $7,142,857 $6,907,143 $7,021,429

*For illustrative purposes only and not intended to represent an actual property.

Let’s assume that we are looking to purchase an apartment building. The broker will make assumptions on the income and expenses based partially on historical information, but also based on comparable properties in the competitive area to create a projected Net Operating Income, or NOI. Based on the assumptions and the numbers above, a 7% cap would make the property worth approximately $7.1MM.

If instead we look at historical results, the T-12 (the trailing 12 months’) NOI would only result in a $6.9MM valuation at the same cap rate. If we take a quick look comparing the two, it appears the Broker has assumed we can increase rents and occupancy at the same time with a moderate increase in expenses.

Looking at the T-6 NOI (using the last six months’ results and multiplying by two to annualize them), we’d get a $7MM valuation. There is a more than 3% swing in values between the lowest and highest value! That may not sound like a lot, but let’s assume we paid the broker’s asking price but the T-6 financials used to estimate the broker’s projected income included some short-term leases that did not renew. We could easily have a scenario where we have $883,500 rental income, but our expenses increase to $450,000. Perhaps property taxes increase on sale. Now, our actual NOI is $433,500. Instead of buying a 7% cap, our actual NOI results in a 6% cap on what we paid; not exactly the bargain we expected!

Alternatively, we may have intelligence suggesting the property is poorly managed and rents are too low. We charge $1.1MM in rent but lose a couple of tenants as a result and are 93% leased. Assuming $500,000 in expenses (we increase staff and marketing costs), our realized NOI is $523,000. Instead of buying a 7% cap, our actual NOI results in a 7.3% cap. If $523,000 was our projected NOI and we were willing to pay a 7% cap, we could bid as much as $7.47MM to acquire the property. If another prospective buyer did not have the same foresight to see that rents should be raised, we have created a competitive advantage for ourselves which makes us more likely to be awarded to deal.

Conclusion

Cap rates are useful, but only if we have a good handle on what our NOI should be. Historical results are not indicative of future results, but certainly are one guide. What’s more important is how we underwrite our NOI: can the market support higher rents, are expenses too high? not high enough? Assuming two buyers are willing to purchase at the same cap rate, the one who can find more NOI (increasing income, or operating more efficiently) will be able to offer a higher price. If two buyers have the same NOI, the one with the lower cap rate requirement will be able to offer the higher price.

 

Please note: 1031RPS.com and its associated personnel are not tax professionals, and they recommend investors consult with their tax advisor to ensure their 1031 Exchange is within the IRS guidelines established.