Serving your real estate investor clients, you'll need to be able to aid them in the valuation of income properties. A common method used, among others, is the capitalization rate, or "cap rate." Once your client has an income property under consideration, you can help them to see if the asking price is justified by using the current cap rate for comparable properties and the net income this property generates.
Key Takeaways
- Cap rate is one way real estate investors can determine the value of a property they're interested in buying.
- You can calculate cap rate by dividing a property's net operating income by its listing price or market value.
- Cap rate is just one of many valuation tools you can use to determine if a property is worth its purchase price.
What Is Cap Rate?
Capitalization rate, "or cap rate," is a calculation tool used to value real estate—mostly commercial and multi-family properties.Cap rate is the net operating income (NOI) of the property divided by the current market value or purchase price. NOI equals all revenue from the property minus all necessary operating expenses.
Determine Property Income That Justifies the Asking Price
If your client knows the asking price of a property and the current cap rate for similar properties, you can calculate the net rental incomes necessary to justify the asking price.
For example, if a property sold for $1,000,000 and the total revenue after expenses or NOI was $150,000, the cap rate would be 15% (150,000/1,000,000 = .15, or 15%).
What if other properties in the neighborhood also sold for a similar amount but only yielded $100,000 in NOI? The cap rate for those properties would be 10%. A lower cap rate in this example could be the result of a lower NOI due to higher operating expenses (leading to a lower profit from the investment) or lower revenue earned on the properties.
Note
By analyzing the cap rate and the net operating income earned on properties in the area, you can get a sense of what the potential return will be on the property you're looking to buy. From there, you can determine if the asking price is too high or not.
Other Calculations to Value a Real Estate Investment
Part of your value as a real estate agent or broker is to assist them in determining the true value of a property. Using the capitalization rate is one of several valuation tools that can provide your clients a good understanding of what a property is worth.
Net Operating Income
Net operating income is the net result of revenue from the property minus operating expenses. However, NOI is calculated before taxes and doesn't include principal and interest payments on any loans.
Net Rental Yield
The rental yield is similar to NOI but takes into account taxes. You can calculate the monthly rental income minus monthly expenses and tax payments. From there, you divide that figure by the market value price to get net rental yield. It's important to include repair costs and upkeep as well.
Gross Rent Multiplier
Gross rent multiplier (GRM) is calculated by dividing the market value of the property by the annual gross income. The GRM figure gives you an approximate return on a property without factoring in expenses. The GRM is easy to calculate but isn't a very precise tool for ascertaining value.
Cash Flow of a Rental Property
Cash flow analysis is helpful in determining how much monthly income (or cash) is left over after repair costs, expenses, and a vacancy rate. Properties might sit idle for a few months and vacancy should be factored into the analysis. Cash flow analysis is helpful in providing the monthly income to earn back your initial cash outlay for the down payment or any repairs.
Gross Scheduled Income and Effective Gross Income
Gross scheduled income (GSI) helps you know what income will be realized if a property is fully occupied and all rents are collected. Take the number of units times annual rent for GSI.Once you know theGSIof a real estate investment property, we arrive at theeffective gross incomeby subtracting out the estimated annual losses due to non-payment or vacancies.
Depreciation of a Rental Property
You can calculate the depreciation of a building by deducting out the value of the land and dividing the building value by 27.5 years for annual depreciation.For example, a building is valued at $245,000, so we divide $245,000 by 27.5 years, which equals $8,909 in annual depreciation.
Note
Depreciation can be used as a tax deduction.
Breakeven Ratio for Rental Property
Lenders use the break-even ratio as one of their analysis methods when considering providing financing for a real estate investment property. The breakeven ratio factors income gross rental income, total debt payments, and all operating expenses. Too high of a break-even ratio is a cautionary indicator.
Frequently Asked Questions (FAQs)
Do you want a high cape rate or low cap rate?
In general, a higher cap rate indicates could indicate more risk. Cap rates are similar to the bond market. A bond with low rates is a safer investment than a bond with high rates.
How do you calculate building value with cap rate?
To calculate cap rate, you divide a property's net operating income by its listing price or market value.
FAQs
The capitalization rate is calculated by dividing a property's net operating income by the current market value. This ratio, expressed as a percentage, is an estimation of an investor's potential return on a real estate investment.
How do you value a property based on cap rate? ›
Cap Rate Example
The direct capitalization method, one of the core real estate appraisal techniques, states the value of a property can be estimated by dividing its stabilized NOI by the market cap rate. Given the 6.0% market cap rate, the implied market value of the property is $200 million.
How do you figure the value using the income capitalization approach? ›
Investment Value – value of an investment property to a particular investor; may not equal market value. IRV – notation for the basic capitalization formula used in the income approach where: Income divided by Rate equals Value. V = I ÷R • Know this income approach formula!
What is income Capitalisation method of property valuation? ›
The income capitalization approach to appraisal assigns a property value based on the estimated returns of a property. It ultimately determines the market value of a property. For Sarah, this number, the market value, is the maximum allowable purchase price if one wants to achieve one's desired rate of return.
How do you calculate the value of an income property? ›
Gross Rent Multiplier Approach (GRM)
GRM valuation method is considered the simplest method of computing the property value. GRM is calculated using the gross rental income without the operating expenses. The formula for computing GRM is GRM = property value / gross rental income.
What does 7.5% cap rate mean? ›
A 7.5% cap rate means the investment property will generate a net operating income which equates to 7.5% of the property's value. For example: A $300,000 property with a 7.5% cap rate would generate a net operating income of $22,500.
What is the cap rate if a building sells for $1000000 with an NOI of $120000? ›
From the information given, if a building sells for $1,000,000 and has a NOI of $120,000, the cap rate would be: Cap Rate = $120,000 / $1,000,000 = 0.12, or 12% if expressed as a percentage.
Why is the going out cap rate critical to valuation of property? ›
It indicates that a lower value cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.
Which valuation approach is most common for commercial real estate? ›
The sales comparison approach is the most common method for valuing commercial property. This method involves comparing the subject property to similar, recently sold properties in the same market.
What value is most commonly used for commercial property? ›
The most commonly used methods to find commercial property value include the cost, sales, income, gross rent multiplier, discounted cash flow and price per square foot approach.
First, calculate the net operating income based on a pro forma model. Then, find the cap rate for the appropriate market and asset class. Finally, divide the net operating income by the cap rate. The result of this calculation is the property's value based on the direct capitalization method.
What is the valuation cap rate method? ›
Cap Rate Formula
The formula for Cap Rate is equal to Net Operating Income (NOI) divided by the current market value of the asset. Where: Net operating income is the annual income generated by the property after deducting all expenses that are incurred from operations including managing the property and paying taxes.
What is an example of capitalization method? ›
For example, a small business bringing in $500,000 annually and paying its owner a fair market value (FMV) of $200,000 annually uses $300,000 in income for valuation purposes. When all variables are known, calculating the capitalization rate is achieved with a simple formula, operating income / purchase price.
What is the 2% rule in real estate? ›
The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.
What is a good cap rate for multifamily? ›
Cap rates generally vary from one property type to another, even within the same geography. For example: an investor might expect multifamily cap rates to be around 4-6% versus office cap rates which may be closer to 6-9%. Retail, hospitality, and industrial cap rates can also vary from market to market.
What is the 1 rule in real estate? ›
For a potential investment to pass the 1% rule, its monthly rent must equal at least 1% of the purchase price. If you want to buy an investment property, the 1% rule can be a helpful tool for finding the right property to achieve your investment goals.
Is a 20% cap rate good? ›
A “good” cap rate varies depending on the investor and the property. Generally, the higher the cap rate, the higher the risk and return. Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location.
Does cap rate include property appreciation? ›
Limitations of the Cap Rate
They do not consider potential property income or market value changes. Cap rates don't account for appreciation: Cap rates do not factor in property appreciation, which is the increase in property value over time.
