CAP RATE

The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. In simple terms, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. See an example

Cap Rate = NOI / Value

Estimated Value = NOI / Cap Rate

Investors, lenders and appraisers use capitalization rates to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. It provides a more reliable estimate of value than a market Gross Rent Multiplier since the cap rate calculation utilizes more of a properties financial detail. The GRM calculation only considers a properties selling price and gross rents. The Capitalization Rate calculation incorporates a properties selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.

Cap rates may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. Investors expect larger returns when investing in high risk income properties. If you would like to find out what the cap rate is for a particular type of property in a given market place, check with an appraiser or lender in that area. Be aware that the frequency of sales for commercial income properties in a given market place may be low and reliable capitalization rate data may not be available. If you are able to obtain a market cap rate from an appraiser or lender for the type of property you are evaluating, check to see if the cap rate value was determined with recent sales of comparable properties or if it was constructed. When adequate financial data is unavailable, appraisers may construct a cap rate through analysis of it's component parts thus reducing the credibility of the results. Cap rates which are determined by evaluating the recent actions of buyers and sellers in a particular market place will produce the best market value estimate for a property. If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.

Net operating income is determined by subtracting vacancy amount and operating expenses from a properties gross income. Operating expenses include the following items: advertising, insurance, maintenance, property taxes, property management, repairs, supplies, utilities, etc. Operating expenses do not include the following items; Improvements such as a new roof, personal property such as a lawn mower, mortgage payments, income and capital gains taxes, loan origination fees, etc.

Appraisers use the Income Approach, Cost Replacement and Market Comparison methods to estimate the value of property. The Income Approach utilizes the theory of Capitalization.

Examples

Cap Rate = NOI / Value

Estimated Value = NOI / Cap Rate

Example 1: A property has a NOI of $200,000 and the asking price is $2,200,000.

Cap Rate at Ask Price= ($200,000 / $2,200,000) X 100 = 9%

Example 2: Using the above property, you as an investor need a 12% Return on Investment. What price would you being will to pay to get an 11% return?

Purchase Price at 11% ROI = $200,000/.11 = $1,818,181

Example 3: A property has a NOI of $98,000 and Cap Rates in the area for this type of property are 6%.

Estimated Market Value = $98,000 / .06 = $1,633,333

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