Cap Rate - Calculations and Application

Capitalization rate (cap rate) is a rate of return used in real estate investing to determine the present value of a real estate investment based upon its future benefits. In other words, a property's price based upon its net operating income.

Cap rate alone does not provide a true picture of an income property's profitability, but it is one of the most popular returns used for real estate investing because it provides a quick first-glance look at an investment property's ability to pay its own way. Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property all typically use cap rate in one form or the other.

Cap Rate Calculations

In practice, you will use capitalization rate to express the relationship between a rental property's value and its net operating income for the current or coming year and can be used to achieve three useful purposes.

1. Compute a property's cap rate. When you want to know the cap rate for, say, a recently sold property, you would use that property's net operating income and sale price to determine the cap rate it sold for.

Cap Rate = Net Operating Income / Property Value

2. Compute a property's estimated value. In preparation for a listing presentation, for instance, you can use the net operating income you estimate for that property and the cap rate for a similar, recently sold property to suggest a price.

Property Value = Net Operating Income / Cap Rate

3. Compute a property's net operating income. In cases where you are given a specified price and cap rate you can determine what the net operating income should be.

Net Operating Income = Property Value x Cap Rate

There is no universal capitalization rate; it depends on individual market areas. What might make a rental income property a steal in one city or state at a 5% cap rate, might not get a second look in another. The important thing is to use realistic income and expense numbers to make your calculation. It will only lead to trouble if you don't.

About the Author

James R Kobzeff is the developer of ProAPOD Real Estate Investment Software.

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