You are looking to buy an apartment building or other commercial property and as you look through the paper work, you see CAP Rate. But what does it mean and how is it calculated? You have at least heard of the term, but it was never clear to you as to what meant.

The CAP Rate is simply dividing the Net Income with the purchase price of the property.

If you were to purchase a multi-family property for $1,000,000 (assume that you are buying all cash) and that property has a rent roll of $100,000. From the $100,000 rent roll, there are expenses (such as taxes, water, fuel oil, repairs, etc) that need to be subtracted. Let's assume that those expenses are $40,000 per year.

This makes your Net Income $60,000 ($100,000 - $40,000 = $60,000). Simple enough to calculate.

Now for the CAP Rate, you divide the purchase price by the Net Income ($60,000 divided by $1,000,000 = 6%). This would be your CAP Rate for this property, 6%.

Once the purchase price is agreed upon, that is a fixed number and easy to use in this calculation. Where it gets a little tricky, is what expenses are included in order to obtain Net Income?

Realistically, ALL expenses associated with operating costs of this property should be included as expenses and subtracted from the Total (or Gross) Income.

Here is a list of expenses which I use to quickly evaluate a property and its CAP Rate (there could be others).

• Ø Vacancy - there will always be a certain vacancy factor which can vary geographically among other factors. A standard for this is 5%, though I just read a report in the Wall Street Journal that US vacancy rates are at 7.8%, a 23 year high.
• Ø Advertising - you will incur advertising fees in order to fill vacancies. I use $25 per unit as a measure.
• Ø Auto & Travel - how far is the property? How often will you go there? Meeting tenants, renting apartments, picking up supplies, etc. I use $50 per unit as a measure.
• Ø Payroll - does the property employ a super or handyman? This should be a known figure.
• Ø Legal Fees - evictions and or other legal fees, chances are they will be an expense at some point. I use ½ of 1% as a standard measure (of course it can vary).
• Ø Management Fees - will you hire a management company or manage the property yourself? Either way, that is a function of operating and should be considered an expense. This expense can vary, but many times it's 6%.
• Ø Repairs - I generally use 5% of my Gross Income as a basis for repair expenses (of course this can vary from year to year).
• Ø Supplies - you will always need supplies, cleaning products, garbage bags, salt, etc. I use 1% as a standard measure (of course it can vary).
• Ø Taxes - property taxes are fixed, but we all know that they seem to be ever increasing.
• Ø Electric - hallway and property lighting, powering boiler or other equipment. This should be a known somewhat fixed figure.
• Ø Water & Sewer - this should be a known fixed number but also has a general tendency to increase year after year. If the property has well & septic, there are expenses there as well. Water testing, purifying, softening as well as septic clean-outs.
• Ø Fuel Oil - this is very important if property has one central boiler where the landlord supplies the heat. Oil prices over the past few years have sky-rocketed. I used to be able to calculate this number by multiplying the number of units with $1,000, but this is no longer accurate (these days, it's more like $1,200 - $1,500 per unit).

Some of these expenses do no apply to every property, depending on its location and design. For me they apply 99% of the time. There may be other operating expenses to consider that may be specific to a region or a particular property. You would be wise to make sure nothing major is left out of the equation.

I had been fixed on buying apartment buildings at 8% CAP rate. Come to find out, there are brokers listing properties for sale at 8% - 11% CAP Rate. Needless to say, that got me all excited since it was at or above what I expected. But when I did my calculations, the CAP rates changed drastically. Many times they would drop down to 5% or 6%.

How did these proposed CAP Rates vary so much from my own estimations? This is the part where the buyer has to be clear on ALL operating expenses. If the seller leaves out the vacancy and management expenses, this alone would greatly change the CAP rate.

Recently I had negotiations with sellers/brokers who would swear that their property has high CAP Rates. They are either unclear as to how to calculate CAP Rates or they are intentionally leaving things out in hopes that the buyer will not pick up on it.

The area that is of most interest to me these days is the Bronx. As it turns out, an 8% CAP Rate is fairly equivalent to 6 times the rent roll. So in the case of our example above, where the property had an annual rent roll of $100,000, the purchase price should be in the ballpark of $600,000. I also find this interesting because in the past, apartment buildings in the Bronx were always priced on the basis of Gross Rent Multiplier (usually around 5 to 6 times the rent roll). Now I understand why buildings were priced this way, it was much simpler yet very consistent to the CAP Rate.

Can you buy apartment buildings at 6% CAP Rate or 8 times the rent? Yes, of course, but your return on your risk, work and investment would not make it a good investment. And unless you held on to that property for a very long time, it just might even be a bad investment.

Of course there are many variations and factors, but this is the basis of CAP rates.

If you own or are looking to buy apartment buildings in the Bronx area, please feel free to email me with any questions or comments.

Peter Nikic, Licensed Real Estate Broker (NY)        

(914) 804-0037

Broad & Bailey, Inc                     

 http://www.broadnbailey.com/                  

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