How to Calculate and Use Cap Rate for Investment Real Estate Analysis

Anyone involved with real estate investing is undoubtedly familiar with the term capitalization rate yet might not understand what it means or how to use it in a real estate analysis. It seemed appropriate, therefore, to devote this article to the popular rate of return.

Capitalization rate, or cap rate, is the rate at which you discount future income to determine its present value.

But having said that, don't get hung up on the technical definition. For our purposes, simply regard cap rate as the relationship between a property’s net operating income and its value. That capitalization rate expresses what percentage rate a property’s net operating income is to its value.

A common mistake made by those just getting started with real estate investing is thinking that there is one ideal cap rate. But capitalization rates vary from area to area and from investor to investor. The cap rate for an apartment complex in Los Angeles, for instance, would not be expected to be the same as it would be in Boston, Massachuttes, or that one capitalization rate would satisfy the investment goal of all real estate investors.

Furthermore, it's important to bear in mind that cap rate alone doe not provide a true picture of a property’s profitability and is not generally used apart from other criteria to make real estate investment decisions. Capitalization rate, at best, should merely be considered a rule of thumb that provides a first-glance assessment of a rental property’s ability to pay its own way; thereby used by real estate agents, appraisers, investors, property tax assessors, and other real estate analysts in three ways.

1. To compare similar income properties in the area
2. To calculate a reasonable estimate of an income property value
3. To calculate an income property’s net operating income

1) Compare Similar Income Properties in the Area

In this case, you would need to compute the cap rates for each property and then compare them. Bear in mind that the higher the cap rate is the higher the return and thus the better for the investor.

Formula: Net Operating Income/Property Value = Capitalization Rate

Example: Say a real estate investor wants you to locate several multifamily properties priced at around $500,000 with a cap rate of 8.0%. As a result, you discover one rental property listed at $490,000 with a net operating income of $40,000 (Property A) and another listed at $510,000 with a net operating income of $43,000 (Property B).

Property A: $40,000 divided by $490,000 = 8.16%
Property B: $43,000 divided by $510,000 = 8.43%

Result: Both properties meet the investor's buying criteria of an 8.0% cap rate (remember, 8.0% or higher is what you want) so your create a real estate analysis and present them.

2) Calculate a Reasonable Estimate of an Rental Property Value

Formula: Net Operating Income/Capitalization Rate = Property Value

Example: Say you’re preparing a listing presentation and want to advise the owner of a commercial office complex with a net operating income of $65,000 what the property is worth based on a 6.8% capitalization rate for similar properties in the area.

Result: $65,000 divided by 6.8% = $955,882, which you decide to round up to $960,000 and suggest to the owner as a reasonable estimate as a fair market price for his office complex.

3) Calculate an Rental Property’s Net Operating Income

Formula: Property Value X Capitalization Rate = Net Operating Income

Example: Say a real estate investor wants to purchase an apartment complex at your city's prevailing cap rate of 7.0%, or better. You hear of 5-unit building for sale at $300,000 and obtain the owner's statement of income and expenses. What net operating income would you expect to find?

Result: $300,000 times 7.0% = $21,000. Unless the net operating income equals or exceeds $21,000, you know that the desired cap rate for that specific property is not achieved.

Please allow me to say that ProAPOD® Real Estate Investment Software computes capitalization rate automatically as you enter the property data for any rental income property, of any size. The cap rate is recalculated each time you make changes to sale price, income, and expenses so it is always accurate. Reports such as the APOD, proforma income statement, rent scenarios, marketing package and assumptions all reflect cap rate.

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