An Insider's Look at Cap Rate

Capitalization rate (or cap rate as it is more commonly called)is a rate of return at which you discount future income (net operating income) to determine its present value (price).

Although cap rate alone does not provide a true picture of a property's profitability, because it provides a quick first-glance look at a property's ability to pay its own way, capitalization rate is one of the most popular returns used for real estate investing.

Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property typically all use cap rate in one form or the other.

HOW TO USE

In practice, you will use capitalization rate to express the relationship between a property's value and its net operating income for the current or coming year.

As a result, you can use the cap rate formula to achieve three useful purposes.

1) Compute a property's cap rate - When you want to know the cap rate for a recently sold property, for instance, you would use that property's net operating income and sale price to determine the cap rate it sold for as a way to compare it against similar properties.

2) Compute a property's estimated value - In preparation for a listing presentation, for instance, you can transpose the formula and compute a property's estimated value and then use that value to see how it measures up to recently sold properties of similar configuration.

3) Compute a property's net operating income - In cases where you are given a specified price and cap rate, you can transpose the formula again to determine what the property's net operating income should be.

FORMULAS

1) Capitalization Rate = Net Operating Income divided by Property Value

2) Property Value = Net Operating Income divided by Cap Rate

3) Net Operating Income = Property Value times Cap Rate

We want to look at three examples to drive the formulas home. But, first, it's crucial that you understand net operating income and the role it plays in making capitalization rate such a popular real estate investing return.

Mathematically, net operating income equals the gross operating income of an income property less the sum of all its operating expenses. If your rental property produces an annual income of $30,000, for example, and its annual operating expenses are $12,000, then the net operating income produced by your rental property would be $18,000.

When a property is not financed, net operating income, by virtue of the fact that there are no mortgage payments to deduct, is the cash flow. When the property is financed, then net operating income represents the amount of money available to make the mortgage payment, which is why NOI and returns such as cap rate and debt coverage ratio (both computed using NOI) is important to lenders.

Okay, on to our examples.

EXAMPLES

1) Calculate cap rate: Assume that a rental property sold for $300,000 and had an NOI of $30,240. To make the calculation you will divide the net operating income by the sale price (30,240 / 300,000). The capitalization rate is 10.08%. Now you can compare this rate to the rate similar properties sold for and determine whether it is in line with the market.

2) Calculate property value: Assume that a rental property has a net operating income of $26,676 and you want to know its value based on a capitalization rate of 7.41%. To make the calculation you divide the NOI by the cap rate. The value is $360,000. Now you know, based on similar properties, what the fair market value for this property should be.

3) Calculate net operating income: Assume that an apartment complex sold for $810,000 at a capitalization rate of 5.77%. To make the calculation you will multiply the price by the rate (810,000 X 5.77). The NOI is $46,728. Now you know, based on the price and capitalization rate, what the net operating income is.

IMPORTANT

Here are four closing thoughts you should take with you.

1) There is no such thing as a universal capitalization rate. It depends on individual market areas. Whereas a 6% rate might suggest a bargain in Los Angeles, it might not get a second look in Salem.

2) Cap rate provides an easy way to compare various investment properties, but you would be wise to never rely on it alone to provide a true picture of a property's profitability. Real estate investing decisions must never be made without first computing all the cash flow, rates of return, and profitability scenarios correctly.

3) Remember that numbers can be manipulated. When someone tells you that an income property has a desirable cap rate, reconstruct your own raw data to insure that nothing is being concealed before you actively pursue the real estate investment further.

4) Real estate investment software solutions typically calculate capitalization rate and net operating income and include it in such reports as the APOD.