How to Use Cap Rate to Figure Rental Property Fair Market Value

cap rateSay you are a real estate agent that just received a call from an apartment complex owner that is considering to have you sell his property but would like you to suggest the apartment’s fair market value and listing price. What do you do next?

In this article we will show you how you can use a popular real estate investing return called the cap rate to make that determination quickly and easily.

For those of you who are not familiar with the term, cap rate (or capitalization rate) expresses the relationship between a rental property’s value and its net operating income (NOI) for the current or coming year.

Okay, let’s get started.

To begin with, you must establish what the average capitalization rate is in your local area based upon recent sales activity for similar properties. Since you will be using this “average” to compute a fair market value for your seller’s property, it is very important that you have a clear understanding of what this means.

You want to be certain that the average rate reflects the same-type of income properties. In this case,you want it based upon recent sales of similar-type apartment buildings and not upon the recent sales of office or industrial complexes. Secondly, you must be certain when reviewing the sold listings that any cap rates indicated in that sales data reflect reliable income and expense data and not simply a listing agent’s hyperbole. The idea is accuracy. You certainly don’t want to suggest a fair market value based upon faulty data that might result in an over-priced listing you waste your time on, or worse, an under-priced listing that could alienate your apartment seller.

Okay, let’s take it step-by-step. Hopefully it will provide you the information you need to follow through with the seller’s request and enable you to recommend a reasonable and realistic fair market price for his or her apartment complex.

Settle Average Rate

The first thing you want to do is to settle on the average cap rate rental properties similar to your seller’s apartment complex have recently sold in your market area. There are a number of ways to do this including gathering the information from a local appraiser, county tax assessor, real estate colleagues, MLS and so on.

For our purposes, let’s assume that you were able to obtain this from a local appraiser and are comfortable using a cap of 8.0% as the average rate.

Confirm Property Data

Next, you must confirm and validate the income and operating expenses your seller is telling you that his apartment building annually produces. This means you must examine each carefully so you can calculate an accurate net operating income. You do this by deducting the property’s annual operating expenses from annual rental income.

We’ll say that your research and effort produces a net operating income of $41,500.

Make the Calculation

Okay, now you’re ready to compute a fair market value for your seller’s apartment complex. Simply divide the net operating income you calculated by the average capitalization rate you settled on and you’re done.

Net Operating Income / Average Cap Rate = Fair Market Value
$41,500 / 8.0% = $518,750

So You Know

ProAPOD provides a real estate agent software solution that automatically computes capitalization rate for a range of reports that real estate agents can create and use for listing presentations.