# Quick question on understanding CAP Rate

#1

When arriving at the “Net Income” portion (top number of fraction) of the cap rate, is the cost of the monthly loan payment figured in to this number?

Example:
Yearly Income = \$100,000

• Cost to operate = \$40,000 (summarized for utilities, upkeep, salary, taxes, etc)
= \$60,000
• \$30,000 Loan Repayment at \$2500 / Month
= \$30,000 NET

So, for CAP Rate top number, do I use \$60K or \$30K?
Thanks,
Michael

#2

Cap rates are calculated on Net Opetating Inome (NOI) which is all income less operating expenses such as utilities management etc.
Debt service is not included in NOI

#3

Cap rate would be 6% in this example

#4

Which means you use the \$60,000 for your calculation in cap rate. That number is the net operating income as TJgordon mentioned. Cap rate will vary based on the price you pay for this property.

#5

How would you know CAP rate without knowing value/purchase price? Wouldn’t the cap rate only be 6% if it was a \$1,000,000 park?

#6

I’m not sure I understand the question. \$60,000/1,000,000 is 6%. You need two of the three numbers to arrive to one of the values.

#7

@korntera… This is how I understand the concept of Cap Rate:

The formula is:

Net Operating Income divided by Cap Rate = Valuation

You can solve the equation for whatever number is not provided. Investors use the Cap Rate basically as their “Rate of Return” number … so if I wanted to only buy parks that give me the valuation of a 10% cap rate… then I use the NOI and a 10% cap rate to decide what I am willing to value the park as for my investment purposes. As an example … As a seller knowing that the MHC across the street sold with a 8.5% cap rate two years ago … you would not convince me to give you a sale with a valuation using a 10% cap rate, no matter how much you wanted it., but as a buyer I would try to get the value at or as close to the 10% cap rate valuation as possible because that’s where I want the numbers. You use the NOI and the asking price and you can get the cap rate the seller is starting from. It is sort of a “guage number” for your desired rate of return as an investor … it is not set in stone by any means. You use that formula as a general tool to get an idea of the valuation you are willing to give the property and start negotiating from there.
That’s the best understanding I have … (not being a finance person). Not sure if it helps but take it with a grain of salt and at your own risk… LOL.

#8

If the price of the park was \$1mm then 6% cap rate. However, don’t forget that NOI is a fuzzy number that’s based on sellers stated operating costs, which may (will) not be your true operating costs.

Also, don’t forget that deferred maintenance! Capital reserves should be ~25% of your expenses and that’s not included in NOI.

#9

That’s an interesting point Brandon. I’ve seen many buyers / appraisers figure a 3% reserves expense line item in their estimated operating expenses. I’ve seen almost no sellers use this, but have seen some of the more sophisticated sellers include it separate before cash on cash. It can make a huge difference in value even at 3% if it’s included in the NOI calcs. You’re saying you keep it separate but estimate it as 25% of your total expense figure?

#10

no. its relative to the purchase price. what you can do is work backwards. What cap rate do you need? Youll have to be flexible based on owner financing, potential for expansion etc. what cap rate do you need to be satisfied with a deal?

#11

3% reserves sounds good if you mean 3% of purchase price per year meaning you’ll pay the purchase price in amount of repairs over 33 years.

3% of NOI at 10% cap rate would be repairing the park to the tune of the purchase price over 333 years. That’s ridiculous as a real world concept. Things deteriorate over time.

I think you are quite right that the conventional wisdom says set aside “only” 3% not 25% but in reality you’ll end up with capital expenses at some unknown rate depending on your deferred maintenance and that’s not captured in any cap rate discussion.

You take your profit but at some point you’ll have to plow some money back in. 25% of your income is probably too much but… best figure more than 3%.

#12

I completely agree. I’ve seen 3% of gross rents used as the norm, but doesn’t seem like enough if anything substantial actually needs to be fixed. Then again, I typically try to nail down anything that has to be fixed in the near future on the front end and then add it to the purchase price and figure out what my return is based on my “all in” number. How do you figure the real number when you’re looking at potential buys? And do you expense any of this in the NOI or keep it completely separate?

#13

3% of expenses is different from 3% of the gross is different from 3% of the purchase price. How long do roads last? Not forever. Pipes, electrical? If you figure a 50 year average lifespan then 2% of cost to rebuild is the right number.

Cost to rebuild is surely higher than your income, so 3% of your income is going to be too low. If you don’t do capital investment and improvement then you end up putting the money in when its time to sell and the Buyer demands it.

A quick-and-dirty calculation: You could buy a park at \$50k per lot, at a 7% cap rate will spin off \$3500 per year “profit” on a gross of \$10,000 per year. If rebuilding a lot costs, say, \$25k in today’s dollars and a lot (along with the pro-rata portion of infrastructure) lasts for 50 years, then you should save \$25k / 50 = \$500 per lot per year for capital improvement. That’s 5% of your gross.

But your bank might require only \$50 per lot per year maintenance reserve. Ours does.