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A cap rate is a building's net operating income divided by its price. Turn it around and you have a value, net operating income divided by the cap rate. The division takes a second. Everything hard about the method lives in the income figure, so most of this page is about building that figure the way a buyer will.
- Net operating income, or NOI, is collected income minus operating expenses. Loan payments, depreciation and income taxes are not operating expenses.
- Capital projects such as a roof are not a monthly bill, but a buyer still pays for them, as a yearly reserve or as a lower price.
- In-place NOI uses today's rents and actual bills. Pro forma NOI uses rents someone expects later, and it can make almost any price look reasonable.
- A cap rate only carries over from a comparable sale if that sale's NOI was built the same way as yours.
What a cap rate measures
The cap rate is the first-year return a buyer would earn by paying all cash. A lower rate means a buyer is paying more for each dollar of income, which happens when that income looks safer or looks likely to grow. A higher rate means a buyer is paying less, because the income looks riskier or flatter. The State Board of Equalization's appraisal course calls the same figure an overall rate and teaches deriving it from sales, which is where this guide tells you to get yours.
Because value is NOI divided by the rate, the two inputs behave differently. An error in NOI moves the value by the same proportion, so an NOI that is 10 percent too high gives a value 10 percent too high. An error in the rate moves it more than you might expect. Dividing by 5 percent gives a value 20 percent higher than dividing by 6 percent.
Building NOI line by line
California's rule for the income approach, Property Tax Rule 8, describes the same structure appraisers and buyers use. Gross return is what the property yields over and above vacancy and collection losses, and net return is what remains after the outgo needed to produce and maintain that income.
| Line | What goes in | Watch for |
|---|---|---|
| Scheduled rent | Each unit's current monthly rent times twelve | Use the rent roll as it stands, not the rent you plan to charge. |
| Vacancy and credit loss | An allowance for empty months and unpaid rent | Base it on your building's history. A buyer's lender applies its own allowance regardless. |
| Other income | Laundry, parking, storage and similar charges | Count only what tenants pay and you can document. |
| Effective gross income | The three lines above combined | This is what the building actually collects. |
| Operating expenses | A year of the costs of running the building | See the next section. |
| Net operating income | Effective gross income minus operating expenses | Measured before any loan payment. |
What counts as an operating expense, and what does not
An operating expense is a recurring cost of keeping the building rented and running. These belong in NOI:
- Property tax, at the buyer's figure. A sale triggers reassessment to market value under Proposition 13, and the rate is limited to 1 percent of that value plus a rate for voter-approved debt. A buyer replaces your bill with one based on the purchase price.
- Insurance. The premium for the coverage a buyer's lender will require, which may differ from your policy.
- Utilities the owner pays. Water and sewer, trash, common-area electricity, and any gas or electricity on a meter shared by the units.
- Repairs and maintenance. Including the cost of getting a vacant unit ready for the next tenant.
- Management. Count a management fee even if you manage the building yourself, because your time is not free and the next owner may hire someone.
- Services and contracts. Landscaping, pest control, cleaning, elevator and fire system servicing.
- City fees. Inside the City of Los Angeles, the annual rent registration and code enforcement fees.
These do not belong in NOI:
- Mortgage payments. Principal and interest are the owner's financing, not the building's cost.
- Depreciation. It is a tax deduction on paper, not cash spent. Rule 8 excludes amortization, depreciation, debt retirement and interest on funds invested in the property from the outgo it counts.
- Income taxes. They depend on the owner, not the building.
- Personal costs run through the building. A car or a phone on the building's books is the owner's expense, and a buyer will strip it out.
How depreciation and your own tax position affect what you keep from a sale is a question for a CPA. Shaya Lowenstein is a real estate agent, not a CPA or attorney, and this page is about value, not tax.
Debt service and capital expenditures
Debt service is the loan payment. NOI comes before it, and what is left after it is cash flow, which is a different number and not the one a cap rate uses. Your current loan does not change what a buyer's lender will allow, because that lender tests the buyer's new payment against the building's NOI. Freddie Mac's small balance program, for example, describes requiring NOI to exceed the payment by a minimum debt service coverage ratio.
A capital expenditure replaces or improves something with a long life: a roof, a boiler, a repipe, windows, a seismic retrofit. It is not a monthly bill, but it is not free either. Rule 8 counts capital expenditures, or annual allowances for them, as part of the outgo needed to produce and maintain the income. In practice a buyer accounts for them one of two ways. Some deduct a yearly replacement reserve from NOI. Others leave NOI alone and take the cost of known work off the price. Watch for both at once. A buyer who deducts a reserve and also cuts the price for the same roof is charging you twice.
In-place versus pro forma
In-place NOI uses the rents tenants pay now and the building's actual bills for the last twelve months. Pro forma NOI uses the rents someone expects after units turn over or after a renovation, and the expenses they expect then. A marketing package can show both columns. Read the in-place one first.
The lender is the reason in-place leads. Freddie Mac's small balance term sheet describes counting income from recent actual rent collections or the current rent roll, less a vacancy allowance. A buyer who pays for pro forma income is paying for money the lender will not count, so the difference comes out of the buyer's cash, and the buyer carries the risk that the rents never arrive. That is why a buyer may pay for some upside but starts from what the building collects today.
Under rent control the gap between the two columns depends on turnover the owner cannot force. The page on rent control and value covers how that works in Los Angeles.
A worked example with made-up numbers
Every number below is invented and rounded so the arithmetic is easy to follow. None of it describes a real building or says anything about what Los Angeles buildings sell for. The example is a ten-unit building where every unit rents for $2,000 a month.
| Line | Example amount |
|---|---|
| Scheduled rent, 10 units at $2,000 a month | $240,000 |
| Less vacancy and credit loss at 5 percent | minus $12,000 |
| Plus laundry income | plus $2,000 |
| Effective gross income | $230,000 |
| Less operating expenses, including $30,000 of property tax | minus $80,000 |
| Net operating income | $150,000 |
| Value at a 5 percent cap rate | $3,000,000 |
| Value at a 6 percent cap rate | $2,500,000 |
The $30,000 tax is 1 percent of a $3,000,000 price, the base rate alone. A real bill adds voter-approved debt rates, and at the lower price the tax would be lower too, so in practice you run the numbers again at each price you test.
Now build the same building's numbers wrong, two ways.
- The seller's old tax bill. Put in a long-held bill of $10,000 instead of the buyer's $30,000 and NOI becomes $170,000. At 5 percent that reads $3,400,000. The extra $400,000 is not there for any buyer, because the first thing a buyer's analysis does is replace the tax.
- Pro forma rents. Assume every unit turns over to $2,400 a month with everything else unchanged and NOI becomes $195,600. At 5 percent that reads $3,912,000. A lender counting actual collections or the current rent roll will not count those raises, so a buyer paying that price is paying the difference in cash.
Shaya can go through your own rent roll and expenses line by line and show you where a buyer's NOI will differ from yours before a buyer does.