What the cap rate is doing for you
Cap rate divides net operating income by purchase price. It is the unlevered yield of the property in year one, and it is the fastest way to compare two deals in different markets before financing enters the picture.
It is also the most abused number in a broker package, because it is trivially manipulated from the NOI side. A cap rate is only as honest as the NOI underneath it, and a broker NOI is almost always more optimistic than a lender NOI.
A low cap rate is not automatically bad
Cap rate compresses where buyers expect rent growth and expands where they expect risk. A 4.6% cap in a supply-constrained Midwest submarket and an 8.2% cap in a market with a heavy delivery pipeline are both rational prices. The number tells you what the market believes, not whether the deal is good.
What matters is the relationship between your cap rate and your debt cost. When the going-in cap rate sits below your all-in interest rate, the deal carries negative leverage and every dollar of debt reduces year-one cash flow until NOI grows enough to close the gap.
Normalize the NOI before you trust the result
- Add a management fee of 3% to 5% of effective gross income if the seller self-managed and left it out.
- Add replacement reserves of $250 to $300 per unit per year.
- Reset property taxes to the reassessed value at your purchase price, not the seller basis. In Texas and Florida this single line moves the cap rate by 40 to 80 basis points.
- Strip one-time items such as an insurance refund or a legal settlement sitting in the trailing twelve.
- Correct vacancy to the submarket rate rather than the in-place number on a temporarily full building.
Run the calculator on the broker NOI, then again on your normalized NOI. The spread between the two cap rates is the negotiating room.
Going-in versus exit cap
The going-in cap rate prices your entry. The exit cap rate prices your sale, and it drives more of your IRR than almost any other assumption. Underwriting an exit cap tighter than your going-in cap means betting the market improves. Most disciplined underwriting expands the exit cap by 25 to 50 basis points over a five-year hold.