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An Insider's Look at Cap Rate

# An Insider's Look at Cap Rate

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Discover the meaning and formulas for cap rate. See the three ways it's used in real estate analysis. Includes formulas and examples.
Discover the meaning and formulas for cap rate. See the three ways it's used in real estate analysis. Includes formulas and examples.

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05/09/2014

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PROAPOD
®Real Estate Investment Softwarewww.proapod.com
An Insider's Look at Cap Rate
James R Kobzeff
Capitalization rate, or cap rate (its more friendly name), is a rate of return used in real estateinvesting by real estate analysts to determine the present value (price) of a real estate investment based upon its future benefits (net operating income).Although cap rate alone does not provide a true picture of a property's profitability, because it provides a quick first-glance look at a property's ability to pay its own way, capitalization rate isone of the most popular returns used for real estate investing.Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estateinvestment property typically all use cap rate in one form or the other.
How to Use
In practice, you will use capitalization rate to express the relationship between a property's valueand its net operating income for the current or coming year. As a result, you can use the cap rateformula to achieve three useful purposes.1.
Compute a property's cap rate
- When you want to know the cap rate for a recentlysold property, for instance, you would use that property's net operating income and sale price to determine the cap rate it sold for as a way to compare it against similar  properties.2.
Compute a property's estimated value
- In preparation for a listing presentation, for instance, you can transpose the formula and compute a property's estimated value andthen use that value to see how it measures up to recently sold properties of similar configuration.3.
Compute a property's net operating income
- In cases where you are given aspecified price and cap rate, you can transpose the formula again to determine what the property's net operating income should be.
Formulas
1.
Capitalization Rate
= Net Operating Income divided by Property Value2.
Property Value
= Net Operating Income divided by Cap Rate3.
Net Operating Income
= Property Value times Cap RateWe want to look at three examples to drive the formulas home, but first, it's crucial that youunderstand net operating income and the role it plays in making capitalization rate such a popular

real estate investing return.Mathematically, net operating income is a property's gross operating income less the sum of alloperating expenses. If your rental property produces an annual income of \$30,000, for example,and its annual operating expenses are \$12,000, then the net operating income produced by your rental property would be \$18,000.When a property is not financed, net operating income is the cash flow. When the property isfinanced, then net operating income represents the amount of money available to make themortgage payment, which is why NOI and returns such as cap rate and debt coverage ratio (bothcomputed using NOI) is important to lenders.Okay, let's look at our examples.
Examples
1.
Calculate cap rate:
Assume that a rental property sold for \$300,000 and had an NOI of \$30,240. To make the calculation you will divide the net operating income by the sale price (30,240 / 300,000). The capitalization rate is 10.08%. Now you can compare thisrate to the rate similar properties sold for and determine whether it is in line with themarket.2.
Calculate property value:
Assume that a rental property has a net operating income of \$26,676 and you want to know its value based on a capitalization rate of 7.41%. Tomake the calculation you divide the NOI by the cap rate. The value is \$360,000. Nowyou know, based on similar properties, what the fair market value for this propertyshould be.3.
Calculate net operating income:
Assume that an apartment complex sold for \$810,000at a capitalization rate of 5.77%. To make the calculation you will multiply the price bythe rate (810,000 X 5.77). The NOI is \$46,728. Now you know, based on the price andcapitalization rate, what the net operating income is.
Important
Here are four final thoughts you should take with you.1) There is no such thing as a universal capitalization rate. It depends on individual market areas.What might make a rental income property a steal in one city or state at 5%, might not get a secondlook in another.2) Cap rate can provide an assessment and comparison of investment properties, but you shouldnever rely on it alone to provide a true picture of a property's profitability. Never make a real estateinvesting decision without correctly computing all the numbers, rates of return, and cash flow