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Capitalization Rate – Cap Rate
Capitalization rate, or cap rate, is the rate at which you discount future income to determine its present value.
To better visualize what capitalization rate is, however, don't get hung up on its technical definition and simply regard cap rate as the relationship between a property’s net operating income and its value; capitalization rate expresses what percentage rate a property’s net operating income is to its value.
There is no one ideal cap rate; capitalization rates vary 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 doe 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, capitalization rate is a rule of thumb that provides a first-glance assessment of a rental property’s ability to pay its own way, and as such, because it is easy to compute, cap rate is popularly used in three ways by real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property.
- To compare similar income properties in the area
- To calculate a reasonable estimate of an income property value
- To calculate an income property’s net operating income
The formula for cap rate is:
Capitalization Rate = Net Operating Income/Property Value
For example, let’s 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.
To compute the capitalization rate for each property, you would divide the net operating income by the sale price. $40,000 divided by $490,000 equals 8.16% cap rate, and $43,000 divided by $510,000 equals 8.43% cap rate. Since both properties meet the investor's buying criteria, you can present them.
The formula for estimate of property value is:
Property Value = Net Operating Income/Capitalization Rate
For example, let’s say 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 the capitalization rate of similar properties in the area, which you already determined to be at around 6.8%.
To compute a suggested property value for the owner's office complex, you would divide its net operating income of $65,000 by the market capitalization rate of 6.8%. The result is $955,882, which you decide to round up to $960,000 and suggest to the owner.
The formula to determine a property's net operating income is:
Net Operating Income = Property Value X Capitalization Rate
For example, suppose 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 capitalization rate.
To compute for net operating income, you would multiply the property value of $300,000 by your investor's cap rate of 7.0% and surmise that the property must generate a net operating income of $21,000.
ProAPOD® Real Estate Investment Software computes capitalization rate automatically as you enter the property data for any rental income property, of any size. The cap rate is recalculated each time you make changes to sale price, income, and expenses so it is always accurate. Reports such as the APOD, proforma income statement, rent scenarios, marketing package and assumptions all reflect cap rate.
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