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.