What is Capitalization Rate in Rental Property Valuation?
Capitalization Rate (or Cap Rate) is one of the most popular returns used by real estate brokers, investors, and appraisers trying to measure the value and profitability of various real estate investment properties.
In fact, it's almost impossible to examine any rental property analysis (e.g., APOD, Executive Summary, or Proforma Income Statement) that doesn't include a calculated cap rate for the property.
Why the popularity? Because it is a relatively easy computation to make, and it does provide a good way to make quick "one-glance" market comparisons between similar-type rental properties in the surrounding market area.
About Cap Rate
What is it?
The rate at which you discount future income to determine its present value.
Okay, but let's keep it simple. So in laymen's terms, let's simply say that a property's capitalization rate is
the ratio (expressed as a percentage) between a property's estimated value and its net operating income (NOI).
In other words, cap rate indicates what percentage of the selling price is attributable to net operating income. For instance, when a real estate investor tells you that he or she wants to purchase an income-producing property with a cap rate no lower than 7.0%, the investor is saying that they do not want the property's net operating income to reflect less than 7.0% of the sale price.
You are about to take a listing on an apartment complex for $1,300,000 with a gross rental income of $200,600, 3% vacancy rate, and operating expenses of 42%. And you want to see whether the capitalization rate is in line with prevailing cap rates (8.5 - 8.75%) in your market area.
= Cap Rate
$112,858 ÷ 1,300,000 =
Capitalization Rate: 8.68%
Since a property price of $1,300,00 based upon the property's income and expenses results in a capitalization rate of 8.68%, and the prices for similar type properties in the local area cap between 8.5 - 8.75%, we can conclude that an asking price of $1,300,000 for the subject apartment complex is inline with the market.
Rule of Thumb
Be diligent. It's not unusual for some sellers and their agents to skew the net operating income by inflating rents and deflating expenses for marketing purposes. Therefore, always examine the numbers carefully and run your own property analysis before making any real estate investment decision.
So You Know
Capitalization Rate (cap rate) is included in all three ProAPOD solutions: