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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.
= Net Operating Income divided by Property Value2.
= 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
©2008 James R Kobzeff. All rights reserved.