Capitalization Rate - Cap Rate
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income
producing properties. Put simply, the cap rate is the net operating income divided by
the sales price or value of a property expressed as a percentage. 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. In a real estate market
where net operating incomes are increasing and cap rates are declining over time
for a given type of investment property such as office buildings, values will be
generally increasing. If capitalization rates are increasing over time and net
operating incomes are decreasing for residential income property in a particular
market place, residential income property values will be declining. If you would like
to find out what the cap rate is for a particular type of property in a given market
place, contact us and we will check 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.
NOI NOI
Cap Rate = -------- Estimated Value = -------------
Value Cap Rate
Example 1: A property has a NOI of $155,000 and the asking price is $1,200,000.
$155,000
Cap Rate = -------------- X 100 = 12.9 rounded
$1,200,000
Example 2: A property has a NOI of $120,000 and Cap Rates in the area for this
type of property are 12%.
$120,000
Estimated Market Value = ------------ = $1,000,000
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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.
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