Cap Rate: The Meaning, Formulas, and Uses in a Rental Property Analysis

Cap rate (the more commonly used expression for capitalization rate) is one of the most popular measurements used by real estate investors and analysts doing a rental property analysis because it can reveal whether or not the value (V) of one specific income property measures up to the market value of similar income-producing properties, as well whether or not the rental property in question produces enough income to make it a profitable investment.

So what is a cap rate? In technical terms, capitalization rate is the rate you discount future income to determine its present value. The idea being that any investment is the present value of future benefits, and thereby with the capitalization formulation, real estate analysts can evaluate those future benefits.

The present value represents cash outflow at the time of investment with all positive cash flows occurring thereafter. The net operating income represents the future cash flow (or income stream) and is defined as income before debt service (principal and interest payments) and before payment of any income taxes owed by the investor as a result of the investment. Tax shelter is not considered in this formulation.

V = NOI / C.R.

Consider the following two examples where you can use this method.

Say that you’re a real estate agent about to take a listing on a ten-unit apartment building and want establish a selling price that is inline with the market. You conclude that the property produces a net operating income of $30,000 (NOI) and based upon your recent comparable studies that similar rental properties have recently sold at a 10% cap rate (C.R.). You would be able to determine that the property has a value of $300,000 (V).

Or, you might be an investor who looks at the property described above when it does get listed at $300,000 and using whatever income and market criteria satisfying to you could calculate the value for yourself using capitalization rate to see whether you agree with the sale price.

This is commonly the approach that real estate investors, agents, appraisers, and tax assessors use to arrive at the value of rental income property. Naturally, there are differences between the value arrived at from an appraisal and one arrived at by a rental property analysis for an investor in a unique investment situation, but the intent and formulation are the same; to determine value.

Okay, but say that you know the value and net operating income on similar rental properties recently sold in the marketplace and want to see how a particular apartment building might compare. In this case, you would want to compute the capitalization rate in your rental property analysis.

C.R. = NOI / V

For instance, if your market analysis reveals that similar income properties to the one under consideration have recently sold for around a 10% cap rate then you should expect the property under evaluation to fare as well or better, otherwise it could be an indication that the property is over-priced and might not be a profitable investment.

Let’s refer back to the ten-unit apartment building spoken of earlier to illustrate the point. In this case, you would divide its net operating income of $30,000 (NOI) by its asking price of $300,000 (V) to arrive at the capitalization rate of 10% (C.R.). If that rate proves to be inline with your analysis of cap rates in the market, fine; otherwise it would appear to be out of line with the marketplace; which might mean that the property is either over-priced and therefore might not be a profitable investment or under-priced and therefore worth pursuing as an investment.

Of course intelligent investment decisions based upon any rental property analysis can only result from evaluation of additional sources of valuation information. But the cap rate method does provide a reasonable way for analysts and investors to consider the value and profitability of any prospective investment. And when properly applied to a realistic net operating income, capitalization rate has been known to help investors avoid paying too much for rental property and thereby increasing the business risk.

You can see how my rental property analysis software implements the cap rate model by following the link provided below.

Internal Rate of Return: Understanding IRR and Why MIRR and FMRR Modified It!

Internal rate of return (IRR), modified internal rate of return (MIRR), and financial management rate of return (FMRR) are three returns used to measure the profitability of investment property. Each method arrives at a percentage rate based upon an initial investment amount and future cash flows, and in each case (of course) the higher the better, but the procedure for making the calculation varies significantly as do the results.

By definition, internal rate of return is the discount rate at which the present value of all future cash flows is exactly equal to the initial capital investment. To make the calculation, negative cash flows are discounted at the same rate (i.e., the IRR) as positive cash flows.

Let’s consider the following investment with the initial investment as CF0 (always a negative number because it is cash outflow) and subsequent cash flows as CF1, CF2, etc., with some negative and some positive.

CF0 -10,000
CF1 -100,000
CF2 50,000
CF3 -60,000
CF4 50,000
CF5 249,300

IRR = 30%

Seems all well and good, but the problem here is that the calculation assumes that the cash generated during an investment will be reinvested at the rate calculated by the IRR, which may be unrealistically high and therefore will overstate the return on initial investment. Likewise, since negative cash flows are also discounted at the IRR, if that rate is fairly high, the investor might not accurately estimate the cash required to meet those future negative cash flows.

To deal with this shortcoming many real estate analysts use a method known as MIRR (i.e., modified internal rate of return). In this approach, the assumption is that positive cash flows the investment generates during its life can be reinvested and earns interest at a “reinvestment rate”, and negative cash flows must be financed at a “finance rate” during the life of the investment. In other words, rather than simply using one rate (i.e., IRR) to deal with both negative and positive cash flows, MIRR introduces the option to use two different rates.

By applying a finance rate of 5% and a reinvestment rate of 10% here’s the result using the same investment criteria as we did earlier.

CF0 -10,000
CF1 -100,000
CF2 50,000
CF3 -60,000
CF4 50,000
CF5 249,300

MIRR = 18.75%

Okay, then along came the financial management rate of return (or FMRR). Though it also provides two separate rates to deal with negative and positive cash flows known as the “safe rate” and “reinvestment rate”, FMRR takes it a step further. The assumption here is that where possible, all future outflows are removed by using prior inflows. In other words, negative cash flows are discounted back at the safe rate and are either reduced or eliminate by any positive cash flow that it encounters. The remaining positive cash flows are compounded forward at the reinvestment rate.

We’ll apply a safe rate of 5% and a reinvestment rate of 10% to our investment criteria to show you the result. But this time we’ll also include a table to show you the adjusted cash flows.

CF0 -10,000
CF1 -100,000
CF2 50,000
CF3 -60,000
CF4 50,000
CF5 249,300

CF0 -111,717
CF1 0
CF2 0
CF3 0
CF4 0
CF5 304,300

FMRR = 22.19%

The financial management rate of return is difficult to compute, which is why most real estate investment software solutions opt for the modified internal rate of return (MIRR) calculation. But after learning about it from CCIM, I considered it a beneficial return for real estate investment analysis, so I included FMRR my ProAPOD real estate investment software as well as my ProAPOD mortgage calculator software. To learn more please visit the link provided below.