Five mistakes that make a cap rate look better than it is
The cap rate is simple: net operating income divided by price. That simplicity is its strength, but also its weakness. Because only two numbers go in, a small error in either one can make an ordinary property look like a bargain. Here are five mistakes we see again and again, and how to avoid them.
1. Using projected income instead of actual income
Sales brochures often quote a cap rate based on a pro forma NOI: the income the property could earn if every unit were let at the highest achievable rent. That figure may be possible one day, but it is not what you are buying today.
What to do: ask for the actual rent roll and the bank statements or accounts for the last one to two years. Rebuild the NOI from what tenants really pay, and treat any planned rent increase as an upside, not as part of the price.
2. Ignoring vacancy and unpaid rent
A building that is fully let today will not stay fully let forever. Tenants move out, units need work between tenants, and some people pay late or not at all. Leaving vacancy out raises NOI and therefore the cap rate.
What to do: subtract an allowance for vacancy and credit loss, based on the property's history or local data. Even in strong markets, a few percent of gross income is a sensible minimum.
3. Leaving out management and maintenance
Owners who manage their own property often skip the management fee, and sellers sometimes show unusually low repair costs because they have postponed work. Both make the NOI look better than a buyer will experience.
What to do: include a market-rate management fee even if you plan to do the work yourself — your time has a value, and the next buyer will price it in. Look at the age of the roof, heating, plumbing and other major systems, and budget realistically for repairs.
4. Using old expense figures
Property taxes and insurance premiums are often reassessed when a property changes hands or when its value rises. Last year's figures from the seller may therefore understate what you will pay.
What to do: ask the local tax office or a tax adviser how a sale affects the property tax, and get an insurance quote for the building at its current value. Update utilities and service charges with recent bills.
5. Subtracting the wrong things — or the right things twice
Some buyers deduct mortgage payments from NOI and then divide by the price. The result is neither a cap rate nor a cash-on-cash return, and it cannot be compared with anything. Others deduct a capital reserve for one property but not for another, which makes the comparison unfair.
What to do: keep NOI clean — income minus vacancy minus operating expenses, nothing else. Look at financing separately with the cash-on-cash return and the debt service coverage ratio. If you use a reserve for future replacements, apply it to every property you compare.
A quick sanity check
Once you have a cap rate you trust, ask two questions:
- How does it compare with recent sales of similar properties nearby? A result far above the local norm usually has a reason that is not in the brochure.
- How sensitive is the value? Use the reverse calculation to see what the property would be worth if buyers expected a cap rate one percentage point higher. If that drop would hurt you, build in a margin of safety.
You can do both in seconds with our cap rate calculator. For a deeper look at each line of the calculation, read our guide on how to calculate net operating income.