How Cap Rate Benefits Rental Property Buying Decisions

Cap rate (or capitalization rate) is a rate of return commonly used for the valuation of investment and commercial real estate by real estate investors, brokers, appraisers, and other income property analysts.

In fact, it might even be said that cap rate is one of the most popular rates of return associated with real estate investing, and perhaps the most widely used to initially gauge investment real estate performance and value.

There are essentially two reasons for this.

  1. The return directly links a rental property’s value to its net operating income for the current or coming year.
  2. The return provides an easy way for real estate investors and analysts to compare similar investment property values in a given area.

In the first case, the benefit of the capitalization rate is that it expresses the relationship between the property’s value (i.e., asking or selling price) to its income after annual operating expenses (i.e., the net operating income).

In the second case, the benefit is that it’s an easy calculation widely used by appraisers and analysts and therefore provides a good way to compare the financial performance and value of one rental property to other similar properties.

In this article we’ll discuss capitalization rate by looking at its formulation and application so you see how to use the return to make your own prudent rental property buying decisions.

Formulation

Foremost, let’s consider the two components required for making the calculation. Namely, property value and net operating income (NOI).

  • Property value is simply the property’s sale or asking price.
  • Net operating income is mathematically the property’s annual gross operating income less the sum of all annual operating expenses. It is typically characterized as the amount of money the real estate investor would receive in a given year (before income taxes and depreciation) if the rental property were purchased for all cash.
Formula

Net Operating Income / Property Value = Capitalization Rate

Application

Let’s assume that you want to determine whether the asking price offered on a rental property under consideration (Property A) is inline with similar rental income properties recently sold and currently on the market. Here are the essential steps.

1. Research the market.
  • First, do a comparable market analysis of all similar rental income properties recently sold (within last year or so). Compute the cap rate for each and average. This establishes an approximate going rate for your local market area.
  • Secondly, compute the rate for each similar property currently listed for sale in your local market area.
2. Calculate Property A.
  • Compute the capitalization rate for Property A by dividing it’s net operating income by its asking price.
3. Compare the rates.
  • First, compare the rate you computed for Property A against the average rate you computed for similar property’s recently sold.
  • Secondly, compare the rate for Property A against the rates you computed for each similar property currently listed for sale.
4. Make your buying decision.

Bear in mind that higher cap rates result in a higher value, and lower rates result in a lower value. Therefore, Property A might be considered a prudent real estate investment if it’s cap rate is higher (or at least equal to) all other cap rates.

  • Foremost, make sure that Property A is inline with the market. This is what the banks will do when considering your financing request. A lower rate for Property A than the average market rate could mean that the asking price is too high.
  • Secondly, see how Property A stacks up against the other rental properties currently for sale. A lower rate might be an indication that there could be better opportunities available.

Consideration

To get an apples-to-apples comparison, you must be sure to obtain the correct income and expenses for each property. This is often difficult to ascertain because it relies solely on what an owner is willing to disclose and, or, how accurately a broker presents that information. So until the income and expenses can be verified, keep in mind that the capitalization rate calculations might be flawed.

What’s the solution?

Use capitalization rates only as a rule of thumb for an easy first-glance assessment and comparison of properties. But never rely on cap rate alone to provide a true picture of a property’s profitability. Prudent real estate analysis always requires you to run and examine all the numbers prior to making any real estate investing decision.

So You Know

ProAPOD Real Estate Investment Software automatically computes cap rate for each rental property you evaluate. You simply fill in the forms.