How the Cap Rate Formula Serves Three Real Estate Investing Purposes

The cap rate formula is undoubtedly the first formula most real estate agents and investors learn when they initially become engaged with real estate investing.

Real estate investors, agents, appraisers, property tax assessors and others that evaluate real estate investment property typically all use cap rate in one form or the other. So it makes sense that they would learn how to calculate it.

Still, some may not be aware that the cap rate formula can be used to serve three useful purposes when dealing with real estate investment property. So in this article, I thought it would be helpful to show you.

Cap Rate Overview

Cap rate is a rate of return used in real estate investing to determine the present value (price) of a real estate investment based upon its future benefits (net operating income).

But that’s the technical definition. In practice, it expresses the relationship between a property’s value and its net operating income (NOI) for the current or coming year.

Although alone it does not provide a true picture of a property’s profitability, it does provide a good first-glance look at a property’s ability to pay its own way. As such, it is one of the most popular returns used for real estate investing.

Cap Rate Formulas

As stated, you can use the cap rate formula to achieve three useful purposes associated with real estate investment property.

1. Calculate a property’s cap rate

When you want to know what capitalization rate a rental property recently sold, for instance, you would use that property’s net operating income and sale price to make the computation.

Capitalization Rate = Net Operating Income / Sale Price

Example: You just saw a newly listed apartment complex for $900,000 that could be what your real estate investor is looking for if its caps above 7.2%. You learn that its NOI is $61,400 and thereafter discover it caps at 6.82%.

cap rate formula cap

Source: iCalculator by ProAPOD

2. Calculate a property’s reasonable value

By transposing the formula you can compute a property’s estimated value. In preparation for a listing presentation, for instance, you can use the net operating income estimated for that property and the prevailing capitalization rate for similar sold properties to suggest what the property should be worth.

Value = Net Operating Income / Capitalization Rate

Example: You have been asked to list an office complex at what you feel to be a reasonable market value. You know that its NOI is $75,240 and that similar-type buildings have recently sold for an average 5.8% cap rate. You suggest a listing price of $1,297,241.

cap rate formula value

Source: iCalculator by ProAPOD

3. Calculate a property’s net operating income

By transposing the formula again you can compute a property’s net operating income. In cases where you are given a specified price and capitalization rate you can determine what the net operating income should be.

Net Operating Income = Capitalization Rate x Value

Example: You just called for a marketing package on a strip center listed at $2,500,000 showing a cap rate of 7.75%. You are expecting to see the property generating an NOI of $193,750.

cap rate formula noi

Source: iCalculator by ProAPOD

So You Know

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James Kobzeff

James Kobzeff has over thirty years experience as a realtor and investment real estate specialist. He is the developer of ProAPOD real estate investment software and freely shares his real estate investing articles.