What Actually IS a Cap Rate?
Part 2: Breaking Down the Calculation
Understanding Income, Expenses, and Common Mistakes
In our last newsletter, we introduced the concept of cap rates using a simple lemonade stand example. We learned that a cap rate is just the yearly profit of a property expressed as a percentage of its purchase price.
Today, we're going deeper to understand exactly what goes into calculating a property's profit, and some common pitfalls to avoid when working with cap rates.
The Cap Rate Formula Revisited
As a quick refresher, the cap rate formula is:
Cap Rate = Net Operating Income (NOI) ÷ Property Value
Let's break down each piece of this formula in detail.
What Exactly Is "Net Operating Income"?
Net Operating Income (NOI) is the annual profit a property generates after paying all operating expenses, but before paying the mortgage or accounting for taxes.
Think of it as answering the question: "How much money does this property make each year on its own, regardless of how I choose to finance it?"
Here's how we calculate it:
NOI = Gross Income - Operating Expenses
Let's look at each part:
Gross Income
This includes ALL money the property brings in, which typically means:
- Rental Income: The main source - money tenants pay to rent the space
- Other Income: Things like parking fees, laundry income, vending machines, storage rentals, etc.
Important: We use potential rental income minus an allowance for vacancy and credit loss.
For example, if your apartment building could bring in $100,000 per year if fully rented, but you expect 5% of units to be vacant or unpaid on average, your effective rental income would be $95,000.
Operating Expenses
These include ALL costs required to run the property:
- Property Management: Either the cost of hiring a management company or the value of your time if you self-manage
- Maintenance and Repairs: Ongoing upkeep like fixing leaky faucets, painting, etc.
- Property Insurance: Annual premiums to insure the building
- Property Taxes: Annual taxes charged by local government
- Utilities: Any water, electric, gas, etc. that isn't paid directly by tenants
- Landscaping/Snow Removal: Costs to maintain the exterior
- Accounting/Legal: Routine legal and accounting services
What's NOT included in operating expenses:
- Mortgage payments (principal or interest)
- Income taxes
- Depreciation (a tax concept, not an actual cash expense)
- Capital expenditures (major improvements like a new roof)
A Simple Example
Let's use a small apartment building to illustrate:
Gross Income:
- Potential Rental Income: $120,000
- Less Vacancy Loss (5%): -$6,000
- Other Income (laundry, parking): $3,000
- Total Gross Income: $117,000
Operating Expenses:
- Property Management (8% of collected rent): $9,120
- Maintenance/Repairs: $7,000
- Property Insurance: $4,500
- Property Taxes: $12,000
- Utilities: $3,500
- Landscaping: $2,400
- Accounting/Legal: $1,500
- Total Operating Expenses: $40,020
Net Operating Income (NOI): $117,000 - $40,020 = $76,980
If this property is valued at $1,000,000, the cap rate would be: $76,980 ÷ $1,000,000 = 0.07698 or approximately 7.7%
Common Cap Rate Mistakes
Now that we understand the calculation, let's look at common mistakes people make with cap rates:
Mistake #1: Including Mortgage Payments
Remember, a cap rate measures how the property performs regardless of how you finance it. Two investors could buy the identical property - one paying all cash and one with a mortgage - and the cap rate would be the same for both.
If you include mortgage payments, you're actually calculating a different metric called "cash-on-cash return," which measures the return on your down payment, not the property's inherent performance.
Mistake #2: Using Actual Instead of Market Rents
If a property's current owner is charging below-market rents (maybe they've had the same tenants for 15 years and never raised rents), using those actual numbers will give you a misleadingly low cap rate.
Conversely, if current rents are above market (perhaps they've recently been raised to unsustainable levels), using those numbers will give a misleadingly high cap rate.
Always adjust to market rates for an accurate picture.
Mistake #3: Forgetting to Account for Management
Even if you plan to manage the property yourself, you should include a management fee in your calculations. Why? Because your time has value, and you want to compare properties accurately.
Plus, if you ever decide to sell, the next owner will likely factor in management costs.
Mistake #4: Using Pro Forma Numbers Without Verification
"Pro forma" means projected or forecasted numbers. Sellers and brokers often present pro forma statements showing what the property COULD earn rather than what it IS earning.
Always verify these projections against historical performance and market reality.
The "Back of the Napkin" Method
Real estate professionals often use a quick shortcut to estimate cap rates:
- Take the monthly rent per unit
- Multiply by 12 to get annual rent
- Subtract roughly 40-50% for expenses
- Divide by the price per unit
For example, if apartments rent for $1,000/month and sell for $150,000 per unit:
- Annual rent: $12,000
- Less 45% expenses: $6,600 NOI
- Cap rate: $6,600 ÷ $150,000 = 4.4%
This is just for initial screening - always do detailed calculations before making decisions!
Why Expenses Matter So Much
Small changes in how you estimate expenses can dramatically change the cap rate. For a $1,000,000 property:
- If expenses are 40% of income, NOI = $60,000, Cap Rate = 6%
- If expenses are 45% of income, NOI = $55,000, Cap Rate = 5.5%
That half-percent difference might not seem huge, but it represents approximately $91,000 in property value ($1,000,000 vs. $909,000)!
Coming Up Next...
In Part 3, we'll explore how cap rates vary between different property types and locations, what market trends mean for property values, and how to use cap rates as part of your overall investment strategy.
Key Terms Explained
Gross Income: All money a property generates before expenses.
Operating Expenses: The costs required to run and maintain a property on a day-to-day basis.
Net Operating Income (NOI): The annual profit a property generates after expenses but before mortgage payments and income taxes.
Pro Forma: Projected or forecasted financial performance, as opposed to actual historical performance.
Vacancy Rate: The percentage of rental units expected to be vacant at any given time.
Market Rent: The amount a property should rent for based on comparable properties in the area.
