A capitalization rate is one year of net operating income divided by a property's price. That is the entire formula. A building that throws off $60,000 of net operating income and sells for $1.2 million trades at a 5 per cent cap rate.
The formula is not where people go wrong. The numerator is. Net operating income is not a number you look up, it is a number somebody builds, and two honest people can build it two ways that land twenty per cent apart. The cap rate inherits every one of those choices without showing any of them.
A cap rate is a price, worn backwards
Flip the equation. Price equals net operating income divided by the cap rate, so a 5 per cent cap rate means a buyer paid twenty times one year of income. A 4 per cent cap rate is twenty-five times. The rate is a multiple in disguise, which is why a lower cap rate means a more expensive building, not a worse one.
It also describes the building rather than the buyer. Net operating income is calculated before any mortgage, so two buyers paying the same price for the same property record the same cap rate and can earn wildly different returns depending on how much they borrowed and at what rate. Anyone who tells you their cap rate is their return has skipped the financing, which for most owners is the largest single line in the year.
What belongs in net operating income
Net operating income is a property's annual income after operating costs and before financing. In:
- Rental revenue, net of vacancy and uncollected rent
- Other recurring income: parking, laundry, storage, pet rent, utility recoveries
- Operating expenses: property taxes, insurance, owner-paid utilities, repairs and maintenance, on-site payroll, snow and grounds, and a management fee
Out:
- Mortgage principal and interest
- Income tax and capital cost allowance
- Capital expenditures
- One-time items that will not repeat, such as a legal settlement or an insurance recovery
Those last two exclusions are where most disagreements live.
The four choices that move the number most
1. The management fee nobody paid
An owner who manages a building themselves writes no management cheque, so the expense line sits empty and net operating income looks higher than the building deserves. The next owner will pay someone, even if that someone is also themselves. Put a market management fee into the statement, quoted the way your market quotes it, whether or not money changes hands. Leaving it out is the most common way a small building's cap rate gets inflated, and it is the first thing an experienced buyer adds back.
2. Vacancy set to last year instead of a normal year
A building that happened to run full for twelve months produces a trailing net operating income with no vacancy in it at all. That is a fact about last year, not a forecast. A defensible statement carries a vacancy and credit loss allowance drawn from how the building and the submarket behave over several years, not from the luckiest twelve months in the file. If you have never separated physical vacancy from the rent you never collected, start with economic vacancy, because that is the figure the allowance is meant to capture.
3. Capital spending filed as repairs
Charge a roof replacement to repairs and maintenance and net operating income drops by the price of a roof in one year, which understates the building badly. Capitalize a genuine repair and the number climbs for no reason. The Canada Revenue Agency publishes the test it applies to rental owners, and it works here too: does the expense give a lasting benefit, does it maintain the property or improve it, and is it for part of a property or for a separate asset. The CRA guidance on current versus capital expenses spells the questions out.
Neither treatment makes the roof free. A serious analysis carries a replacement reserve, a per-unit annual allowance for the roof, the boiler and the parking lot that everyone knows are coming. Some conventions put the reserve inside net operating income and some put it below. Pick one, say which, and apply it to both sides of any comparison.
4. Trailing income or pro forma income
Trailing net operating income uses the last twelve months of actuals. Pro forma income uses what the building would produce once rents reach a level nobody has signed yet. Both are legitimate and they are not comparable. Ask which one a quoted cap rate was built on, over what period, and if it is pro forma, ask which specific units have to turn over at which rents before the number becomes true.
The rate is observed, not chosen
People talk about wanting an 8 cap the way they talk about wanting a return. A cap rate is not a target you set, it is a price the market has already been paying for comparable buildings. Saying you want an 8 cap is saying you want to pay twelve and a half times income, which the seller may decline.
This matters when a value changes. Only two things can have moved: the income, or the rate the market applies to it. Income is the part you manage. The rate follows interest rates, credit conditions and how buyers feel about risk, none of which respond to your leasing. An owner report that says the value fell without saying which of the two moved has hidden the only half of the story the owner can do anything about.
The ten minute version
- Start with the last twelve months of collected income, not scheduled rent.
- Subtract operating expenses, and add a market management fee if none was charged.
- Remove mortgage payments, income tax and capital cost allowance.
- Pull out capital spending and anything non-recurring, then add back a replacement reserve.
- Apply a vacancy and credit loss allowance if the trailing year ran unusually full.
- Divide by the price you would pay, not the asking price.
- Rebuild the comparison property on the same definition before you compare the two rates.
Step seven is the one people skip and the one that makes the other six worth doing. A cap rate is only meaningful beside another cap rate built the same way. On its own it is one building's income over one building's price, which tells you what somebody paid and nothing at all about whether they should have.