Short version: Cap Rate = Net Operating Income divided by Total Value of the Property.
Example: You consider buying a property for sale for $300,000 that generates $35,000 (after fixed costs and variable costs). You verified the income and expense numbers from the seller, and believe they are accurate (very important). Your capitalization rate would be $35K/$300k = 11.7%
In other words, for every $100 you invest in that property, you expect to earn $11.70 per year.
How do you use it?
Cap rate can be used as a way to quickly compare returns on investment between different properties. It is as if you have a cash only purchase, thus if you use financing the cap rate will not be the actual leveraged return you will get.
Calculating Net Operating Income
- Determine gross revenue by adding all the rental, laundry room, and other income.
- Subtract income lost from vacancies. This is effective gross income.
- Subtract operating expenses (maintenance, management, advertising, etc).
- That is your Net Operating Income.
Key to remember for the NOI is all revenues must come from ongoing operations and not a one time asset sale or insurance payout. Also, do not consider depreciation and debt service for expenses. These conventions are used because we are focusing on the asset’s value, and one time events, depreciation, and financing reflect irregular events, tax issues, and capital structure, not value.
Projecting Property Value Given a Cap Rate
Because Cap Rate = NOI / Value, if you have a target Cap Rate you can estimate your max price by dividing NOI by cap rate. Example: 8% target cap rate / $200K = $2.5M. Compare that to what the actual properties are selling for (and verify your assumptions for NOI).
Carefully Consider the Following
Cap Rate does not consider financing. In thoroughly evaluating an investment, you need to consider what your actual return on investment will be, after financing. Also, verify all assumptions of the costs and occupancy rates if you are given a cap rate for a property from another investor or seller.
Consider other factors such as the stability of expected income, property value appreciation, and your alternative investments you could buy instead.
Cap Rates change. In the example above, if the property value appreciates to $350K in a few years, with net operating income held constant, your new cap rate will be $35K/$350K or 10%. This is less favorable and reflects how you could sell the property and purchase another investment. (Or in reality, perhaps refinance.)
Cap Rate’s Similarity to P/E Ratio in Stock Equity Investing
If you invest on fundamentals in the stock market, the Cap Rate can be considered the real estate version of the P/E ratio. The P/E ratio is the market value per share (price) of a security divided by the earnings per share.
This is the inverse relationship of what the Cap Ratio is for real estate investments. A P/E of 20.5 could come from $40 share value and $1.95 earnings per share. This is the “price multiple” or “earnings multiple.” The cap ratio can be considered similar because it is the opposite comparison: the net operating income divided by the value. Much like it is useful to compare P/E ratios of one company to another in the same industry, it is useful to compare similar properties’ Cap Rates.
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