Reading a cap rate on a small commercial listing: adjust the NOI first
By Francisco Williams, CCIM · CCIM · Executive Vice President, Williams Capital Advisors · CalDRE #01979442 · Updated
Short answer
A cap rate is a property's net operating income (NOI) divided by its price. It describes the unlevered yield in year one, not your return after financing. On a listing, ask whose NOI it is: in-place or projected, with which expenses, and with what vacancy assumed.
The formula
Cap rate = NOI ÷ price. Illustrative: $150,000 NOI ÷ $2,500,000 = 6.0%. NOI is income minus operating expenses, before debt service and depreciation.
Three questions
1. Is the NOI in-place or pro forma? 2. Which expenses are reimbursed by tenants (NNN vs. gross)? 3. Are vacancy and reserves included?
| Line | Listing (pro forma) | Adjusted (in-place) |
|---|---|---|
| Gross rent | $200,000 | $185,000 |
| Vacancy | $0 | −$9,250 (5%) |
| Operating expenses | −$50,000 | −$50,000 |
| Reserves | $0 | −$5,000 |
| NOI | $150,000 | $120,750 |
| Price | $2,500,000 | $2,500,000 |
| Cap rate | 6.0% | 4.8% |
Illustrative numbers only; not a valuation of any property.
Worked example: pro forma vs. in-place
Listings often show a cap rate on projected (pro forma) NOI. Recomputing it on in-place numbers, with vacancy and reserves, can change the picture.
Run your own
Use WCA's cap rate calculator and test listings on WCA listings. The glossary defines the terms.
Frequently asked questions
Is a higher cap rate better?
For a given NOI it means a lower price, but it often reflects higher risk. Compare quality, location and lease terms.
Does cap rate include my mortgage?
No. It's unlevered. Debt affects cash-on-cash return, not the cap rate.
What is NOI?
Net operating income: gross income minus vacancy and operating expenses, before debt service.
Sources
Before you sell: what a commercial broker opinion of value covers
What a BOV includes, how it differs from an appraisal, and how owners use it to decide whether to sell, refinance or hold.
Sale-leaseback for business owners: cash out and stay put
How a sale-leaseback works for an owner-occupied building, what buyers look at, and the trade-offs against a refinance.