Capitalization Rate: How to Use and Compute
Capitalization Rate (or Cap Rate, as it's commonly called) is typically used by brokers, investors, and appraisers when they are trying to measure the value and financial 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 computed capitalization rate for the property.
Why the popularity?
Well, having served as a realtor who specialized in income property sales for over thirty years, I think it's safe to say that it's because cap rate has both, the benefit of being a rather easy computation, as well as a good way to make quick "one-glance" market comparisons between similar-type rental properties in the surrounding market area.
What is Cap Rate?
Capitalization rate is technically defined as "the rate at which you discount future income to determine its present value".
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, it 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.
= CAP RATE
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.
As you can see the resulting cap rate is 8.68% and therefore signifies that an asking price of $1,300,000 for the subject apartment complex is inline with its market area.
Rule of Thumb
It's not unusual for some sellers and agents to skew the net operating income by inflating rents and deflating expenses for marketing purposes. Therefore, always examine and run the numbers yourself before making any real estate investment decision.
So You Know
Capitalization Rate is just one of 62 real estate calculators included in Pro RE Calculator that you can compute using your phone, tablet, or desktop.