Whatis is a Capitalization Rate
Like all other significant income property valuation methods, the capitalization rate, or CAP rate for short, involves various calculations of the property’s current/potential income in a market comparison type of approach. With CAP rates, the primary indicator of the property’s value is the income that the property is/would generate. Succinctly explained, the capitalization rate is the annual rate at which the property’s value is capitalized (paid off) by the year’s net operating income. It is therefore similar to the gross rent multiplier, but more accurate as the gross rent multiplier does not consider vacancy losses or operating expenses, but the capitalization rate does. However it is simplified in the sense that it assumes the principal, or property value, remains unchanged for an indefinite period of time & is a single snapshot in time. On another blog, at a later time, we will go into things like Internal Rates of Return (IRR) which will help forecast future values.
The capitalization rate partially varies based on the interest rates being charged in the economy and the general health of the real estate market. The capitalization rate used by valuation experts such as appraisers, banks, etc. historically has varied as low as 4% and as high as 13% in inflationary times.
If interest rates are low then institutional investors do not have a lot of investment choices that provide them high returns. However, if the investment is in a property which is in an area where there seems to be an instability for real estate prices then a higher cap rate will be sought in order to compensate for the higher risk involved.
This basic formula, which is largely used as an index number to property investment buyers, covers the entire investment process.
Formula : Cap Rate = Net Operating Income ÷ Property Value
Capitalization of Net Income
This approach to value computes the value of an investment by comparing the net income from the property to the rate of return necessary to attract an investor to the investment.
Find the value of a property considering that the cap rate is 7% and the net operating income is $40,000
Value = $40,000 ÷ 7% = $571,428.57
The IRV Formula
This formula can be used for three different types of calculations. Whether you are looking to find the property value, establish the cap rate or estimate the net operating income. As long as you have two components of the formula you will always be able to calculate the missing component.
We can use the following diagram to help us remember and apply the various techniques. As long as you have 2 out of the 3 pieces you can come up with your answer, and use the indication from the diagram to use the other components for calculating your desired outcome.
If for example we know the Net Operating Income (NOI) is $100,000 and we want a 10% CAP, you would take the top of the pyramid (I) and divide it by the R (CAP)
I (NOI) is $100,000
R (CAP) is 10%
V (Value) is $1,000,000
Let’s take another scenario where we are told a building is selling for $1,000,000 and at an 8% CAP. Here is how we would quickly see how much income is being generated.
We would multiply the R (CAP) by the V (Value) to come up with I (NOI)
R = 8%
V = $1,000,000
R multiplied by V = $80,000 NOI
We know the (V)alue someone is asking for a property, we know NO(I) the property is generating we now can figure out what is the CAP (R)ate
(V)alue = $1,000,000
NO(I) = $80,000
(I) / (V) = CAP (R)ate of 8%
Here are some different scenarios to see how all these variables work together. Remember as long as you have 2 of the three answered (I,R, or V) you can come up with the third which is missing.
Now that you better understand CAP rates, I encourage you to practice with them as much as possible. Once you’re ready, I encourage you to read my blog post on “Don’t Take CAP Rates At Face Value When Buying Your Next Multifamily Building”. This will demonstrate alternative methods for valuing a property and also when and when to not use CAP rates.
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