Cap Rate - how to calculate with partial vacancy
I have a question about how to calculate cap rate - I am looking at a strip mall on a side road (not many cars/day) 

9,000SF, it is 6 total units 1,500 sf each 

2017 - 
Gross rental income 98,000 (all NNN) 
CAM-Taxes/maintenance/insurance= 43,000

3,000 SF have been vacant for 24+months, so the landlord is paying 1/3 of the CAM/taxes, etc. 

So my question is - if they are asking for a 7% cap rate on the sale - they are arguing that it is based on fully leased (no vacancy) I.e proforma - and an ask of $1.9million - which seems insane to me. 
I am valuing it around $1.1MM with a 7% cap, assuming I will need find a tenant and build out the vacant space. 

Who is correct?

Edit:thanks for the replies. They turned their nose at the offer. The owner has been operating at a loss for 2 years. I guess he will stay in his death spiral, and be bank owned at some point. I had calculated 98k - 1/3CAM($14,333) = $83,666 NOI, and offered $1.1MM for a 7.5% cap - which I thought was generous. I already have a tenant in mind for the other 3kSF at $15/SF - which if it didn’t work out I would occupy 1,500 SF myself.

Edit 2: so I guess it’s somewhere in between? 
I’ve seen a few threads on biggerpockets of guys doing the same thing I am - making a generous cap offer based on actual NOI - or calculating the cap based on current market rates and then putting a line item to account for vacancy to bring price down. 
My question is - at what point (2 years of 33% vacancy, 5 years of 33 vacancy, etc) do you adjust the NOI to account for that high of vacancy? Or do you just drop market rent down from 15 to 12/SF to get to valuation? Lot of wiggle room that would drastically change the price

Edit 3 : ok sounds like I am, in fact, wrong. Honobob sounds like he’s on the money. No meat on the bone on this property. I’d want to be closer to $1.2MM, not sure how I’d get the numbers down that far
[{"id": "e84qxpa", "text": "Do not pay a cap rate on that 100% occupancy number. Move on or buy it at true noi cap\n\nYOU\u2019RE CORRECT! \ud83d\udcaa\ud83c\udffc\n\nOr... get them to sign a master lease for the remainder until you find a tenant or max 18mo. ", "replies": [{"id": "e84xctj", "text": "Most lenders have language against master leases but it\u2019s worth a shot", "replies": [], "depth": 2}], "depth": 1}, {"id": "e84r5t5", "text": "Why would you pay a fully leased up building when it's not fully leased. If they want to use pro-forma fully leased NOI just bump the cap rate since it's not stabilized so you wouldn't get the same cap rate\n\nFrankly a 7 cap on a poorly situated retail strip mall strikes me as insane even fully leased.", "replies": [{"id": "e84xk1y", "text": "Agreed.", "replies": [{"id": "e85ac9w", "text": "Me too - I thought offering 7.5 cap was very generous - the big box stores in town are going for 6% NNN. \n\nHaving a tenant lined up is what made the offer aggressive - existing tenants are NNN through 2025, and I believe I can get the new tenant in a 10yr lease - adding $62k/yr to NOI, and then flip it even for 8% cap with everybody locked in.", "replies": [{"id": "e85dckf", "text": "&gt;  and then flip it even for 8% cap with everybody locked in.\n\nBuy high, sell low?  How does that work out?  Interested in a Bridge I have?", "replies": [{"id": "e85fqos", "text": "Purchase $1.1mil, 7.5% cap based on current NOI \n\nPut new tenant in the vacant 3k SF \nNOI jumps from $83,600 (tenant now pays that $14,333 CAM that landlord was picking up now due to vacancy, also pays $45k in rent) , to new NOI of $142,933 \n\n8% cap puts that at $1.8MM. \n\nAssuming I kick in $60k for TI, $120k for closing/legal/etc, net profit around $520k - yes tell me more about your bridge \ud83d\ude02", "replies": [{"id": "e85g88b", "text": "&gt; Purchase $1.1mil, 7.5% cap based on current NOI\n\nThat ain't how cap rates work.  Yer getting screwed,", "replies": [], "depth": 6}, {"id": "e867o01", "text": "Why would next buyer use 8 cap to arrive at their purchase price? I want to hear your thought process on that one. ", "replies": [{"id": "e868xew", "text": "Properties with tier 1 tenants are going for 6-7% in town. Do you think higher? ", "replies": [{"id": "e869lss", "text": "But why is the next buyer buying it an 8 cap?", "replies": [{"id": "e86a804", "text": "&gt; But why is the next buyer buying it an 8 cap?\n\nHe wants a \"higher\" return!  LOL", "replies": [{"id": "e86ahl5", "text": "for a second, I was scratching my head. Wait so the property is in a better condition for the next buyer with a vacant space leased and the cap rate INCREASES. like wtf. I think there is a misunderstanding that a higher cap means a higher sale price for him. It's in fact the opposite. ", "replies": [{"id": "e86av9j", "text": "Not at all - would offer an 8% because spaces with national tenants are 6-7% in town. Why would a new buyer want this second or third tier piece at the same rate? I\u2019d increase NOI and make the rate more attractive for new buyer ", "replies": [], "depth": 11}, {"id": "e86fyd3", "text": "&gt;  I think there is a misunderstanding that a higher cap means a higher sale price for him.\n\nThe real problem is that so many posters THINK a cap rate is a return and the higher the better.  It is a valuation metric derived from an income approach to value called direct capitalization.  Geez, but the scammers on the internet have worked hard to convince novices that it is a return.  ", "replies": [], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "e84xprc", "text": "&gt; If they want to use pro-forma fully leased NOI just bump the cap rate \n\nNo, the cap rate would be the same. this would be a below the line adjustment.", "replies": [], "depth": 2}, {"id": "e85d8e8", "text": "&gt; Frankly a 7 cap on a poorly situated retail strip mall strikes me as insane even fully leased.\n\n\nFully leased or 100% vacant does NOT change the market cap rate.  Seriously, educate yourself.\n\n", "replies": [{"id": "e869c67", "text": "I see what you are saying. On a property with 2+ years of 33% vacancy - it\u2019s either a line item below - or drop the rate /sf a few $ to make up for it. But IMO this still doesn\u2019t fully account for the risk. \n\nOn this space - \n\n9k SF x $15/sf = $135k NOI (ideally) \n\n135 / 7% cap = $1.9MM\n\n- 12 months to get 3kSF space filled (-45k)\n\n- buildout of 3k SF (-90k) \n\n= $1.75MM \n\nIf you pay 1.75MM for that space currently generating $83k NOI currently - you are out of your mind. \nHow would you value it?\n\nI guess I would just offer a 12% cap based on their ideal NOI ?", "replies": [{"id": "e86a2ty", "text": "&gt; If you pay 1.75MM for that space currently generating $83k NOI currently - you are out of your mind. \n&gt; How would you value it?\n\nI just showed you.  NOI starts with PGI!  Value the building as if 95% full then ALL adjustments are BELOW the line.  You negotiate the risk factor with the seller.  The market determines the risk.  If you are in a hot market he can say I can put a for lease sign in the window and have it leased tomorrow then you are not in a good position to negotiate.  You can counter that why isn't it leased and maybe it was in probate and they knew it would be sold and they thought the market was better for buyers that would want space for themselves, etc.  If the market sucks then you are in a good position to negotiate and even better if YOU know you have a tenant in your pocket.  You'd still be telling the seller that if will take time to lease up and negotiate accordingly.  The way you are coming at him shows that you are a novice and they are not taking you seriously because of your ignorance.", "replies": [{"id": "e86bmwt", "text": "OK yes this makes sense. \n\nOk so I\u2019d say to be safe $14/SF x 9,000 \n\n$126k PGI x 0.95 $119,700\n\n$119,700 x 8% cap = $1.496MM \n\n- 18 months to lease the vacant 3k SF (63k) \n\n- $30/SF to build out 3kSF ($90k) \n\n- risk factor ($100k) \n\n= $1.243MM \n\nWith 20% down that is $994,400 financed at 6% on 30 yr amortization \n$71,544/yr \nBuilding is currently bringing in $83k/yr with current tenants \nSo it would be cash flow positive, 5% cash on cash return as-is, and would jump to 43% cash on cash if get a new tenant (assuming I pay 90k buildout) \n\nIs that correct? \n", "replies": [{"id": "e86fs03", "text": "That is basically it.  You did not subtract expenses which will be around 3% even on NNN.  Also any lease up costs, etc.  You also forgot the vacant space expenses although they should be lower because of variable expenses that depend on use.\nIf you have no 8% cap rate comps and the seller has 7% comps then you are off value by over $200,000.  If all rents are at or close to market then you have no upside but if there are below market leases that are due to expire soon then it would be appropriate to consider that into your negotiations.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "e86afy5", "text": "&gt; I guess I would just offer a 12% cap based on their ideal NOI ?\n\nSee, you are just making up numbers.  ", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e84renk", "text": "Seller - \"when this is 100% occupied it's going to make X, therefore we think it is worth that now\"\n\nYou - \"Ok then let me know when you have it 100% occupied and then we can talk\"", "replies": [{"id": "e86rglk", "text": "No NO NO  Just educate the buyer.  Make your offer based on cap rate comps.  THEN show him the fair below the line adjustments.  You are just walking away from deals because you are lazy.", "replies": [{"id": "e86yjwm", "text": "I'm obviously being sarcastic.  Of course what I said would only start the conversation, where you begin to show the seller what the deal looks like from your side of the table.", "replies": [{"id": "e86ysem", "text": "Sarcasm only works over in the REI board.  LOL  This seems to be a subreddit open to discussion.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e84sgsq", "text": "You can estimate the cost to lease up the building to 100%, including downtime, TI &amp; LC, then subtract that from the 100% occupied value, but I wouldn\u2019t do it.\n\nJust stating another way to come at the Seller if they insist it should be 100% leases cap rate.", "replies": [{"id": "e84xtcv", "text": "&gt; Just stating another way to come at the Seller if they insist it should be 100% leases cap rate.\n\nIf the market is 100% occupancy then yo would pay the market cap rate.  Otherwise it is a below the line adjustment.  \n", "replies": [], "depth": 2}], "depth": 1}, {"id": "e84sozh", "text": "It's the broker's job to get the highest price for his/her client. To the extent that their is a buyer willing to pay the highest price  - and that buyer can close at that price - that is who the broker will advise their client to go with. \n\nIf your analysis of the property and its cash flows makes you think that you can close on the property at X price, submit your LOI at that price.  \n\nThey're effectively asking a 4% cap on in-place cash flows because they are selling the story of the ability to add value by leasing up - and they're trying to capture as much of that value as possible. \n\nThe question you need to ask yourself is are you willing to accept the risk of not leasing the place up in the short-term while only earning 4% on your money? The follow up question is - what rate of return are you willing to accept in the short-term while working towards increasing your return by lease-up?\n\n&amp;#x200B;\n\n ", "replies": [{"id": "e84xf8u", "text": "That broker is a hopeium dealer", "replies": [], "depth": 2}, {"id": "e84xwd2", "text": "&gt; The question you need to ask yourself is are you willing to accept the risk of not leasing the place up in the short-term while only earning 4% on your money? \n\nThe 4% is what buyers and sellers are exchanging a NOI for.  It si not a \"return\".\n", "replies": [{"id": "e855wg9", "text": "You\u2019re not wrong, but nor are you entirely right. The cap rate is the rate of return a property yields if it owned without debt. \nWhile it\u2019s probable that OP will put debt on the property, I don\u2019t know for sure and I don\u2019t think it matters that much anyway. \nThe question still remains as to his analysis if OP believes strongly that they can execute a business plan to lease the vacancy and increase cash flows. \n\nSource: am a real estate investment professional. Masters in RE finance/development &amp; CCIM \n", "replies": [{"id": "e85ch6f", "text": "&gt;  The cap rate is the rate of return a property yields if it owned without debt. \n\nNo, I am 100% correct.   Cap rates have nothing to do with leverage. They are EXACTLY the same on no mortgage properties and 125% leveraged properties.  Direct capitalization measures the value of NOI determined by the market.\nSource.  $40,000,000,000 in appraisal analysis.  Expert witness qualification in CA for valuation. \n", "replies": [{"id": "e85i9gn", "text": "I think you may have misread, I was actually saying that cap rates have nothing to do with debt. \nExample: \nIf you own a property for which you paid $1,000,000\n\nTotal Rental Income: $500,000\nExpenses: $400,000\nNOI: $100,000\n\nThe annual return, or yield, from this property is 10% as the cost basis is $1,000,000. \n\nSimilarly, if you went sell this property for $1,000,000 it would be a 10% cap rate based on current income. \n", "replies": [{"id": "e86lpzg", "text": "&gt; I think you may have misread, I was actually saying that cap rates have nothing to do with debt.\n\nThis is exactly what you said, \"The cap rate is the rate of return a property yields if it owned without debt.\"  \n\n\n$100,000 NOI that the market will pay $1,000,000 is a 10% cap rate market.\n\n$100,000 NOI that a market will pay $2,000,000 is a 5% cap rate market.  In what business world do people pay twice for half the return?   For business reasons people think the $100,000 NOI is worth twice what the EXACT same possible NOI is worth in the 10% market.  Cap rates value the NOI, it is not a return.", "replies": [{"id": "e86njxx", "text": "Okay, chief ", "replies": [{"id": "e86o4ci", "text": "&gt; Okay, chief \n\nLOL You are welcome.  ", "replies": [], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "e857ewl", "text": "What are you talking about? It\u2019s a return. How is it not? ", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e84xypp", "text": "Where on earth did you get the 7%-7.5%cap rate?", "replies": [{"id": "e85a3ao", "text": "NOI 98k - 1/3 CAM/taxes/etc (14,333) = 83k\n\n83k/1.1MM = 7.5 cap", "replies": [{"id": "e85cwjn", "text": "K   Except you don't have even ONE cap rate comp.  If the cap rate comps were 10-10,5% then your $83,000 NOI is only worth $83,000/10%=$830,000 - $83,000/10.5%=$790,500!!!  So YOU overpaid $270,000 to $305,000!!!  I think in real estate terms you are a mark.  Ha Ha ", "replies": [{"id": "e85g8qz", "text": "Huh? How do you know I don\u2019t have comps? In my area - 10% even for mid range is unheard of. It may be in the future if the Fed continues to raise rates but right now properties with tier 1 tenants locked into long term leases NNN are 6-6.5%. Tier 2 7%, the rest is 7-8%. There aren\u2019t many true 10% cap rate properties out there that I have seen. They are usually very risky or very cheap at that rate. ", "replies": [{"id": "e85he0m", "text": "&gt; Huh? How do you know I don\u2019t have comps?\n\nUh, because you cannot provide one verifiable cap rate comp.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "e869h75", "text": "&gt; Who is correct?\n\nSo if they want $1.9 at 7% they are saying NOI $133,000 at 100% occupancy.  No market is 100% occupied time so you would be looking at 5% off that plus NNN expenses at probably 3%.  So NOI of $122,360.  If you have valid cap rate comps of 7% then the market value at stabilized occupancy would be $1,748,000.  THAT IS THE MARKET VALUE except you do not have a building operating to market.   \n\nNow let's say you think you can lease up within a year and costs will be $10,000 plus you are out about $25,000 rent.  But you are also taking a chance that rents will drop or the market will turn and it takes longer to lease.  That is a risk that you want to be compensated for and you need to negotiate that with the seller.  So your offer should be about $1,748,00 less lost rent $25,000 and lease up expenses of $10,000 AND your risk valued at say $50,000.  That gives you $1,663,000.  \nThat is how they are correctly valuing thier building.\n\nNow if you have cap rate comps that support a 7.5% cap rate then the value is $1,631,500 less the $85,000 say %1,546,500.\n\n\nIf you are going to deal in commercial properties YOU WILL NEVER NEED TO CALCULATE A CAP RATE.  NEVER!\n\nLooking at your claim of market rents being $15 then the value is closer to their asking.  I just did simple math to show you HOW to value.  ", "replies": [{"id": "e86bvkg", "text": "Why never calculate cap rate? Isn\u2019t that where you would start on making an offer ? ", "replies": [{"id": "e86g0dv", "text": "Oh HELL NO!", "replies": [], "depth": 5}, {"id": "e86gref", "text": "Think of cap rates like DOLLAR $ per Square Foot.  Some one want to sell you a 1000sf house for $100,000.  So you divide the asking price by 1000 and come up with $100 per SF.  Can you tell me if that is market price or if it is a deal?  Hell NO.  Now if some poser on the internet tells you he bought a house for $80 a SF does that mean YOU should offer $80,000?  Oh hell NO.  You find out he included the garage in the SF so he really only bought 600sf at $80,000 for $133 SF.  So you look for closed sales comps and determine that actual buyers and sellers have exchanged properties for $94,96,102 per SF.  If the $94 property is most similar to yours then 1000SF X $94 = $94,000 is market value.  See how easy when you are not doing it backwards?\n\nThat is why cap rate calculations should be done by a third party ON CLOSED sales where they talk to the buying and selling parties and determine the cap rate.  That creates a cap rate comp.  A cap rate comp details the expenses and the details of the CLOSED sale.  You look at these comps to determine which is closest to the property YOU want to buy and then use the method I detailed earlier using the cap rate comps you have TO DETERMINE LIKELY MARKET VALUE.  ", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "e86kbno", "text": "Edit 3 : ok sounds like I am, in fact, wrong. Honobob sounds like he\u2019s on the money. No meat on the bone on this property. I\u2019d want to be closer to $1.2MM, not sure how I\u2019d get the numbers down that far\n\n\nFCUK, did I just lose another buyer for my bridge?  \n\nBut thanks for staying with me. Most people that have been brainwashed by the scammers on BP get frustrated when they realize they have been bamboozled that they call me a troll and run off.\n\n\nEducate your seller and negotiate.  Ask how he came up with his valuation and work from there. Then show him how you got to your offer. Have you seen the leases.  What if you found out that 3000SF was leased at $30 a SF for the next 10 years to a strong tenent?  See how that changes the value", "replies": [], "depth": 1}, {"id": "e8tn3n3", "text": "It Is", "replies": [], "depth": 1}]