The Capitalization Rate (also known as “Cap Rate”) is used to compare an income property with other similar income properties. It can also be used to place a value on a property based on the income it generates.
The Cap Rate merely represents the projected return for one year as if the property was bought with all cash. But since we don't normally buy property using all cash we would use other measures, such as the cash-on-cash return, to evaluate a property's financial performance.
The Cap Rate is calculated by taking the property's net operating income (NOI) and dividing it by the property's fair market value (FMV). The higher the Cap Rate, the better the property's income and market value. The Cap Rate is calculated as follows:
Capitalization Rate = Net Operating Income / Value
Let's look at an example. Let's say your property's net operating income (NOI) is $50,000. And let's say that the market value of your property is $625,000. Your Cap Rate would be 8%.
Capitalization Rate = Net Operating Income / Value
Capitalization Rate = $50,000 / $625,000
Capitalization Rate = 8.0%
As another example, let's suppose you are looking at purchasing a property that has a net operating income of $20,000. From doing a little research you know the average Cap Rate for the area is 7.0%. By transposing the formula we can calculate the estimated market value as follows:
Value = Net Operating Income / Capitalization Rate
Value = $20,000 / 7.0%
Value = $285,715
An advantage of the Cap Rate is that it provides you with a separate measure of value compared to appraisals where value is derived from recent sold comparables (which are primarily based on physical characteristics). This is especially true when comparing commercial income properties.
Note that a small difference in the Cap Rate may not seem like much but it can make a large difference in your valuation. For example, the difference between a 7.0% and 7.5% Cape Rate, a mere 0.5% difference, on a property with a $50,000 net operating income is a $47,619 difference in value! So be sure to double check the accuracy of your numbers.
As always, you want to look at multiple financial measures when evaluating income property including the cash-on-cash return, debt coverage ratio, and internal rate of return.
