Cap Rate

What is a Cap Rate?
Topic: Cap Rate
In the previous post we discussed the Net Operating Income(NOI) and how it aids in estimating value in an income producing property. When an income property is acquired by an investor, it is not the property per se that is being purchased, it is the income stream that is being bought.

So how does Capitalization Rate or "Cap Rate" come into the valuation formula? Cap Rate is defined as the ratio between the property's NOI and its value. So then, Cap Rate = NOI/Value, if you need a more indepth definition of NOI then you may want to revisit our posting on February 1, 2006. But to recap NOI is Gross Scheduled Income less Vacancy and Credit Loss less Operating Expenses.

Gross Scheduled Income (-) Vacancy and Credit Loss = Effective Gross Income, then Effective Gross Income (-) Operating Expenses = NOI.

Simple Right? just remember that an Operating Expense includes items such as insurance, utilities, ,maintenance, and managment fees. Items not considered Operating Expenses include debt service, depreciation, or income taxes.

Cap Rates are used exclusively in valuing income producing real estate, so brokers, lenders, investors and appaisers understand it and use it, not always correctly, but are familiar with the term. So then should you. Cap rates are property and market specific, so any "market cap rate" figure your given should be taken in context with consideration that a cap rate is based on a specific point in time, usually the current operating year and does not predict future performance of that market or that property class.

That being said lets get down to understanding how cap rates are used to determine value. Remember cap rate is the rate at which you discount future income to determine its present value(PV).

Given a particular property's NOI and it value, which is probably a sellers asking price you can make a determination of cap rate, you can then find out if the property exhibits a cap rate that's inline with other similar properties in that area if you purchase at asking price.

Example- A multifamily apt. complex has a NOI of $58,000. The seller is asking $450,000. What cap rate are you purchasing at?
Cap Rate = NOI/Value
Cap Rate = $58,000/$450,000
Cap Rate = 0.13 or 13%

Cap Rate can also be used to calculate an estimate of value, this is useful in negotiating the sellers asking price. Using the prevailing cap rate and NOI what should this property be worth?
Example: A high rise office building is listed by a broker that has a current NOI of $70,000 and the prevailing cap rate is 10%, the owner is asking for $850,000. Given the information what is your estimate of value? We just transpose the formula to solve for value.

Value = NOI/Cap rate
Value = $70,000/10%
Value = $700,000

The formula for Cap rate is also usful in estimating what a property's NOI should be based on the prevailing cap rate and the sellers asking price. In other words when you call the listing broker to inquire about the property what NOI should you expect to hear.

Example: You find a Mobile Home Park listed for sale at $1,200,000 with a Cap rate of 11%, what NOI could you expect to achieve?
NOI = Value X Cap rate
NOI = $1,200,000 X 11%
NOI = $132,000

As you can see cap rates are very useful in determining a property's value, it is important to obtain accurate information about the cap rates in your desired investment area to determine if the property is providing a competitive return. This information is readily available from brokers, appraisers, other investors, and internet sources such as www.realtyrates.com