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Commercial Real Estate Cap Rates and Valuation

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Anyone new to the commercial real estate valuation game is probably beginning to hear words such as “cap rate”, “rent roll”, and “NOI” used often in the marketplace.  The goal of this article is to help you decode this kind of language in order to determine how to value investment commercial real estate.

Whereas the acquisition of a business is primarily valued based upon an EBITDA multiple, Investment Real Estate (e.g. apartment buildings) is generally valued based upon using a capitalization rate “Cap Rate”.  A detailed explanation of the EBITDA multiple and how to value a business can be found here.  But this article will solely focus on explaining the methodology and rationale of using a Cap Rate to value commercial property.

To value commercial real estate using a Cap Rate, there are three primary steps (below).  To simplify explanations, we will assume the real estate property is an apartment building.

1)    Determine Income

A Rent Roll is a spreadsheet/report that provides unit-by-unit detail of a property that helps investors calculate the Gross Potential Rent (best case scenario) for a given property.

  •  Gross Potential Rent is derived from the Rent Roll and is the maximum annual income at full occupancy and current market rent. This is one’s starting point to which adjustments have to be made such as loss-to-lease, vacancy, non-revenue units, bad debt expense, and concessions must be deducted from. In order to calculate the income one must consider, among other deductions/increases, the following adjustments:
  1. Loss-to-lease: If you have a Rent Roll as of today, and you have leases that were signed several months ago, those lease actual rates (in a rising rent environment) are probably below “market”.  Loss-to-lease totals the amount of this deduction for all units for their respective remaining lease terms. Note, should the property be experiencing a gain-to-lease (in a falling rental environment), this will be a positive number.
  2. Vacancy: This is a standard deduction that accounts for any vacant units.  If the market rent on an apartment unit was $1,000 per month and the unit remained vacant all year, then the vacancy expense would be ($12,000) for this unit.  Vacancy is the sum of all vacant units over the period analyzed.
  3. Non-Revenue Units:  This is the deduction for any units that no rental income will be collected on.  For example, if an apartment building has two model units and allows one leasing agent to live in the building for free, then there will be a total of three non-revenue units.  If the market rent on them is $1,000 per month then for the year the Non-Revenue expense would be $36,000.
  4. Bad Debt Expense:  Bad debt accounts for any uncollected billings that are deemed uncollectible.
  5. Concession Expense:  Concessions account for financial incentives provided to tenants to sign leases.  For example, an apartment building may run a special for new tenants that sign a 12-month lease to get the first month free.  Assuming that the apartment could be rented for $1,000 per month, then the total concession for this unit over a 12-month period would be $1,000.
  • Other Income:  Most properties have several streams of additional income.  It is important to add these additional streams.  Some examples could be garage space rental income, antenna income, pet fee income, utility reimbursement income, late fee income, etc.

The grand total after each of the above sources of income and deductions to market rent is commonly referred to as the Effective Gross Income.

2)    Calculating Net Operating Income “NOI”

  1. Think of this as your annual net profit from the property
  2. NOI Calculation: (Effective Gross income – Expenses”).

                                            Expenses are generally grouped into the following buckets:

  • Payroll: Accounts for all payments to employees at the property
  • Marketing: Expense for all efforts to attract and retain renters at the property.  This may contain items such as locator fees where third party agents are paid a lump sum in exchange for bringing a signed lease to the property.
  • Contract Services: Accounts for all payments for recurring services to the property such as landscaping, security, trash removal, snow removal, etc.
  • Repairs & Maintenance: Expense for all ongoing repairs that are made at the property.  However, this does not include large capital items life roof replacements that may be amortized over time.
  • Turnover: The expense related to apartment units switching tenants which includes items such as carpet replacement, painting expense, etc.
  • SG&A: Expenses typically include administrative expenses like supplies and miscellaneous items that don’t fall under the other buckets.
  • Management Fee:  This is generally tied to the rental income that the property makes and is the fee paid to the third party management company (if applicable).
  • Utilities:  This is the expense related to electric, gas, heating, water, HVAC, etc.  This may or may not be charged back to the individual tenants depending upon whether a RUBS (Resident Utility Billing System) is in place.
  • Insurance:  Property insurance on the building
  • Real Estate Taxes: Taxes on the building

NOI:  After each of the above expenses is deducted from the Effective Gross Income, one can determine the NOI.  However, some asset classes like apartments will also deduct a Capital Reserve after the NOI before applying the cap rate.  Capital Reserve is, for lack of a better description, a cushion that banks/investors assume must be maintained for each unit in case there’s prolonged vacancy, repair needs, etc.  (e.g. for apartments, the capital reserve is generally $250-$300 per unit, depending upon the age of the building.)

3)    Identifying Market Cap Rates for comparable properties

  • The best way to determine the value of anything is to find out what a similar item recently sold for…a comparable (“comp”) property.
  • Cap Rates are generally calculated by dividing a property’s NOI (from the year it was sold) by its sale price.
  • Cap rates are one of the primary metrics banks use to find the market value of investment commercial real estate; if a similar building down the street was sold for a 7% Cap Rate, your building might be given the same Cap Rate to create a fair starting point for valuation purposes.  Cap rates should really only be used on stabilized assets, meaning the properties have achieved the maximum expected on-going occupancy level.  Note, 100% is rarely considered stabilized since tenants will create natural vacancy when they move in and out.
  • Market Cap Rates can be found in online resources such as and (just to name two, neither of which we are associated with).
  • Wick Kirby from HFF LP cautions that tax implications can have a significant impact on a sale process: “In most cases if a property has been held by the same investor for 20 years, there will be a much larger tax “pop” than if the property was held for just 3 years.  Therefore, it’s sometimes necessary to look at a Cap Rate with the current taxes as well as what the cap rate would be with the post-sale taxes (post tax pop and therefore lower NOI).”
  • According to Rob Stanek from The John Buck Company, “Once you’ve found a Cap Rate for properties that most closely match your property type/location, plug that Cap Rate into the following calculation: ($NOI / Cap Rate%).  This is the estimated market value of your property.  Cap Rates generally range from 5% to 10% depending on the size, occupancy rate, location, and characteristics of the rent roll at each property.”

Let’s use an example to illustrate the calculation for a 3 unit building:

4) Valuation:  Since the property was previously sold at a 10% cap rate, has meaningful vacancy, and is most similar to Comp 1 that had a 10% cap rate, we’ll assume the buyer will also assume a 10% cap rate.  With an NOI after capital reserves of $79,100 and a 10% cap rate, the property will likely be sold for at least $791,000 ($79.1k NOI / 10% cap rate).  When a buyer sees that they might be able to increase rents to market rate, they may be willing to pay a higher sale price, especially in a competitive market.

You may have noticed there’s one key difference between the EBITDA Multiple method used to value a business, versus the Cap Rate method used to value investment real estate; the multiple is a factor multiplied by your operating income…the Cap Rate method, however, divides operating income by a factor.  In essence, the EBITDA multiple assumes value is based upon the cash the company will generate in the next 5-7 years (a 5x-7x multiple).  By dividing cash flow by a factor, the Cap Rate method assumes the property will generate the current operating income in “perpetuity” (forever).  As a result, the Cap Rate is a much more aggressive methodology to value an asset, which is great for the seller!  Buyers, be sure to always ask about the Cap Rate assumptions before buying any property to ensure you’re paying a market price.

Special thanks to Wick Kirby from HFF and Rob Stanek from John Buck Company for their thoughtful contributions to this article.

~Brandon Hinkle/


Written by entrabanker

August 2, 2012 at 4:25 pm

Posted in Uncategorized

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