Real estate investor software solutions

Capitalization rate (also known as cap rate) is technically defined as the rate at which you discount future income to determine its present value.

Let's not get hung up on its technical definition, though. To better visualize what capitalization rate is in layman's terms simply hold to the idea that cap rate expresses what percentage rate a property’s net operating income is to its value.

There is no one ideal capitalization rate because it varies from area to area and from investor to investor. The cap rate for an apartment complex in Los Angeles, for instance, would not be expected to be the same as it would be in Seattle, or that one capitalization rate would satisfy the investment goal of all real estate investors.

Moreover, cap rate alone does not provide a true picture of a property’s profitability and is not generally used apart from other criteria to make real estate investment decisions.

At best, think of capitalization rate as a rule of thumb that provides a first-glance assessment of a rental property’s ability to pay its own way. And because it's easy to compute, it is popularly used by real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property for that purpose.

The Formulas

Here are three separate formulas associated with cap rate that you might find helpful the next time you are working with rental property and trying to address a question.

1) The formula for arriving at the cap rate itself.

Example. Say a real estate investor wants you to locate several multifamily properties priced at around $500,000 with a cap rate of 8.0%. As a result, you discover one rental property listed at $490,000 with a net operating income of $40,000 and another listed at $510,000 with a net operating income of $43,000 so you calculate each to determine whether they meet with your investor's demand.

Capitalization Rate = Net Operating Income/Property Value
$40,000 / $490,000 = 8.16%
$43,000 / $510,000 = 8.43%

Since both properties are close to your investor's price range and each indicates a better rate than what was asked for you can present them both.

2) The formula to estimate a property's value.

Example. You’re preparing a listing presentation and want to advise the owner of a commercial office complex that has a net operating income of $65,000 what the property is worth based on a 6.8% capitalization rate of similar properties in the area.

Property Value = Net Operating Income/Capitalization Rate
$65,000 / 6.8% = $955,882

You decide to round up to $960,000 and suggest that as a reasonable market price for the owner to list the building.

3) The formula to determine a property's net operating income.

Example. A real estate investor will not purchase any income-producing property at more than a 7.0% cap rate. You hear of one property for sale at $300,000 and want to know what net operating income it must produce to meet your investor's desired buying criteria.

Net Operating Income = Property Value x Capitalization Rate
$300,000 x 7.0% = $21,000.

In other words, once you receive the marketing package from the listing agent you would expect the property to have a net operating income of $21,000 or more. If not, the property is undoubtedly not producing enough income for your investor to pay their asking price.

So You Know

ProAPOD® real estate agent software as well as our other solutions compute cap rate automatically as you enter the property data. It is recalculated each time you make changes to sale price, income, and expenses and automatically posted to the reports. Learn more at www.proapod.com

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