Posted by Ed Garcia on March 08, 2000 at 10:08:42:
Explaining a Cap Rate:
You take your NOI which stands for (Net Operating Income).
Divide it by the Cap Rate you desire.
This helps you decide the value of the property based on the income.
You have a property that nets you $2500. a month after expenses.
You then multiply $2500. times 12 months = $30,000.
Lets say you want a 8 cap rate.
You then take $30,000. divide it by .08 = 375,000.
At an 8 cap the value of your property is $375,000.
GLD, now here is a more detailed explanation.
Why do you in invest in income-producing real estate? Perhaps you are
looking cash flow. Possibly you anticipate some tax benefits. Almost
certainly, you expect to realize a capital gain, selling the property
at some future time for a profit.
Your projection of the future worth of the property, therefore, can be
a vital element in your investment decision.
A fairly simple approach to this issue is the use of an inflation
rate. You bought the property today for X dollars. You make a
conservative estimate as to the rate of inflation, apply that rate to
your original cost and improvements and come up with presumed future
The use of inflation as a predictor of future value typically makes
sense when the desirability of the subject property is based on
something other than its rental income. For example, consider a
single-user property such as a small retail building on a main
thoroughfare. The owner of a business operating as a tenant in such a
location is probably willing to spend more for the building than an
investor would pay. In general, rate of inflation as a predictor of
future value may be appropriate when comparable sales work well as a
measure of present value (i.e., "Commercial buildings on Main Street
are selling for $200 per square foot by next year they will be up to
With most other types of income-producing real estate, what you paid
for the property is not likely to make much of an impression on a new
buyer. Witness the rapid run-up and even faster collapse of prices in
the late’s. The typical investor will be interested in the income
that the property can generate now and into the future. He or she is
not buying a building so much an income stream.
That investor is most likely to use capitalization of income as the
method of estimating value. You have probably heard this referred to
as a “Cap Rate” method. It assumes that an investment property’s
value bears a direct relation to the property’s ability to throw off
Mathematically, a property’s simple capitalization rate is the ratio
between its net operating income (NOI) and its present value:
Cap. Rate =NOI/Present Value
Net operating income is the gross scheduled income less vacancy and
credit loss and less operating expenses. Mortgage payments and
depreciation are not considered operating expenses, so the NOI is
essentially the net income that you might realize if you bought the
property for all cash. If you purchase a property for $100,000 and
have a NOI of $10,000, then your simple capitalization rate is 10%.
To use capitalization to predict value requires just a transposition
of the formula:
Present Value =NOI/Cap. Rate
The projected value in any given year (i.e., the “present value” in
that year) is equal to the expected NOI divided by the investor’s
required capitalization rate.
To use capitalization rate as a predictor of future value, in short,
is to use this logic: "I am buying this property with the expectation
that its net operating income will represent a return on my
investment. It is reasonable to assume that whoever buys the property
from me in the future will have a similar expectation. That new
investor will probably be willing to purchase the property at a price
that allows it to yield his or her desired rate of return (i.e.,
If you project that the property will yield a NOI of $27,000, and that
a new buyer will require a 9% rate of return (capitalization rate),
then you will estimate a resale price of $300,000.
You must never forget that, while the algebra involved here is simple,
the judgments you need to make in order to achieve an accurate
prediction of value are more complex. Your assumptions as to future
years’ income and expenses have to be realistic.
The same is true of your estimate of a new buyer’s required cap
rate. Look at the investment from the new buyer’s point of view and
remember that there are other opportunities competing for his dollar.
Would you buy an office building with a projected cap rate of 9% if
you could buy a bond that yields 8%? What if mutual funds are rocking
and rolling at 15% and more? To attract a buyer, your property may
need to be priced so that its cap rate is competitive. The higher the
cap rate, the lower the price. In our example above, the property with
the $27,000 NOI capitalized at 12% would be worth only $225,000.
Our discussion here has been limited to simple capitalization rates.
If you would like to delve deeper into this topic (for example,
mortgage-equity cap rates), an appraiser’s text on income-property
valuation should be your next step.
For more information, go to http://www.realdata-inc.com
Copyright 1996, RealData ©, Inc.
Reprinted with permission of the author.