What’s all of the confusion around cap rates, you ask? Isn’t a cap rate just NOI divided by value? It should be easy, right? It is. We’ll simplify it for you. There are a few major specific “classifications” of cap rates that you might hear thrown around in the industry: T12 or In-Place or Year 1. How are they different and what do they represent? Let’s use an example.
Buyer John has an accepted offer to buy a 20-unit multifamily property for $10 million. The seller reports a $500,000 NOI for the twelve months immediately prior to acquisition. John thinks he can save some money on expenses and increase rents and he projects a $550,000 NOI for the twelve months immediately following the acquisition. During the month of acquisition, annualized revenues are $1 million and annualized expenses are $490,000 so the in-place NOI is approximately $510,000.
Notice the difference in NOI calculations that drives the difference in cap rate. Assume market cap rates are 5.25%. Buyer John thinks he’s getting a deal because he believes there are operational inefficiencies that he can capitalize on and earn a premium to prevailing market yield. On the other hand, the seller thinks he is also getting a great deal because he is selling at a 5.0% T12 cap rate while the market bears only a 5.25%.
There is no right or wrong answer; many sophisticated investors analyze all of the different types of cap rate calculations to truly understand the yield that their investment will generate. It is true that the T12 cap rate is fact while the Year 1 cap rate is pro forma (or speculative). John thinks he can raise the NOI but he will only know once he makes the changes that he thinks are necessary.