Cap Rates seem to be abused and misunderstood

A Capitalization rate or Cap Rate for short is a common mathematical calculation that appraisers use to calculate the value of income producing properties. It is defined as the Net Operating Income (NOI) divided by the sale price. What appraisers do in a nut shell is they take Cap Rates from recent comparable sales then average them to get a going rate for a certain type of property in a certain area at a certain time and then divide the NOI by the Cap Rate to get the estimated value of the building they are trying to appraise. However, what I have seen more times than not is that the NOI is not calculated properly. This of course creates an unreliable estimate of value. Investors and Realtors should understand that there is a system of protocol for obtaining NOI. First the expenses have to include management. The business must run by itself with a manager. Otherwise the buyer is just buying a job not a business. Next the income must be adjusted. In other words, expenses like amortization and interest on long term debt have to be removed from the expenses and added back to the bottom line. That is why we call these add-backs. This process is called normalizing the income. Realtors and investors alike should be aware that an improperly reported Net Operating Income will dramatically skew the estimated value of any income producing property. Sellers and their Realtors tend to make the NOI as high as possible and the opposite is true for buyers and their Realtors. However, there is a standard protocol for calculating the NOI and buyers and sellers should hire an experienced commercial Realtor to sort this out for them. I think that sounds a little self serving but only because it is of course.  

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