The value of a commercial property isn’t in bricks, concrete, or pipework. It’s in a building’s ability to generate income. That’s why most CRE investments are often compared using capitalization rate (cap rate).
Cap rate is the net operating income (NOI) divided by the purchase price of a building, expressed as a percentage. By measuring the value of real estate this way, you get a sense of the rate of return you can expect compared to the amount of money you’d spend to acquire a building.
But traditional cap rate (aka “purchase cap rate” or “actual cap rate”) has a glaring gap; it doesn’t account for rehab costs.
That may not be an issue in a buy-and-hold investment of a class-A building with no deferred maintenance issues. But if you’re hoping to use the BRRRR (buy, rehab, rent, refinance, repeat method) or to fix-and-flip a property, rehab costs can take a huge cut out of your potential income—and decrease the value of your investment.
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Pro forma cap rate, on the other hand, does include rehab cost in its calculation. That’s why investors who intend to grow wealth by increasing rental income through property improvements need to understand how pro forma cap rate works—and then apply it to their investment valuation comparisons.
What is pro forma cap rate? Pro forma cap rate is a tool for evaluating the return on investment of a property. To calculate a pro forma cap rate, divide yearly net operating income (NOI) by the total acquisition cost (purchase price plus repair expense).
NOI / [total acquisition cost (purchase + rehab)] = pro forma cap rate
Pro forma cap rate is a useful tool for comparison because it is:
A high cap rate is good for buyers—you're getting more income for your investment. A low cap rate is good for sellers—you’re getting a high sales price compared to the income you could make if you were to hold on to the property.
The math of calculating pro forma cap rate is simple. The challenge is deciding which details to consider in each factor of the equation.
Net operating income is the total income less all operating expenses. It’s common for sellers to show an overly optimistic NOI by not including all costs and using an unrealistic income.
To make sure you’re evaluating an investment fairly, include these factors in your calculation:
However, be careful that your rental income takes into account vacancy rates. If the average vacancy rate in the area is 30% and you’re assuming your property will be 100% full all the time, you may be overestimating the value of the investment.
For operating expenses, include:
NOI listed by sellers often leaves out management fees. Unless you plan to manage the property yourself, make sure they’re included.
The other half of the pro forma cap rate equation involves the amount of money you’ll spend acquiring and repairing a property to bring it to market standards.
Rehab costs can be tough to estimate, especially since commercial real estate isn’t subject to the same rules of disclosure as residential real estate. You’ll need to complete thorough due diligence to understand what work needs to be done.
Once you’ve gathered the net operating income, purchase price, and rehab cost, you can plug them into the equation and calculate your pro forma cap rate.
Here’s a simple example of the complete pro forma cap rate calculation.
Purchase price = $500,000
Rehab costs = $80,000
NOI = $40,000
$40,000 / $580,000 = 6.9% pro forma cap rate (rounded)
So this investment would yield a 6.9% pro forma cap rate. You can then compare this return against other properties or even other investments like government bonds to see which provides the best return on your money.
Pro forma cap rate is useful when scrutinizing your next potential investment and understanding the value of existing assets.
Pro forma cap rate is a comparative metric; a “good” cap rate is only the one that looks most favorable compared to other options.
That’s why pro forma cap rates are such a great tool to assess where you should place your next investment. You’re not stuck comparing investments against a static, and sometimes unachievable, benchmark. Instead, you look for the best option in the market or property class that interests you at the time you are able to invest.
For example, a 2019 CBRE report showed the average cap rate (without rehab costs) in Boston was around 4.5% and in Tampa was around 6.5%. You would have been thrilled to find a 5 cap property near Boston Harbor since it’s higher (more income yield) than the average. At the same time, you’d likely pass on a 5 cap property near Tampa Bay since you’re likely to find higher yield options there.
With a little market knowledge and algebraic magic, you can flip the pro forma cap rate calculation to give you an updated value of your own property.
Let’s say you’ve owned a building for a decade and need to get a current value. Use the average cap rate in your market and make the purchase price the unknown.
Purchase price: ??
NOI: $50,000
Average actual cap rate: 6.25%
$50,000 / (purchase price) = 6.25%
or
$50,000 / 6.25% = $800,000 purchase price
If a new owner would have rehab costs, you can add those in to get the pro forma cap rate.
Pro forma cap rates give you a quick idea of return on a potential CRE investment. But they’re only as good as the information they’re based on.
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Unfortunately, too many sellers and brokers will leave some expenses out of the NOI calculation or assume zero vacancies when no building in their area is fully leased. That’s why you’ll need to scrutinize the cap rate offered by any seller to make sure you know what they’ve included and what they’ve left out.
