Cap rate is a financial metric that is used by real estate investors to analyze real estate investments, and determine their potential rate of return based on annual returns. It is calculated based on the net income that a real estate investment is expected to generate over a one-year time horizon, which can help an investor make a decision on whether to buy or not to buy.
When calculating the cap rate, we take the ratio of the net operating income to the asset value of the property. The property asset value, in this case, is the purchase price that an investor is willing to pay for the property or the asking sales price for the property.
Cap rate is a metric that investors use to determine the expected rate of return based on the expected annual income of a property.
The cap rate is calculated by finding the ratio of the net operating income to the current market value of the property.
It helps investors determine if a property to be purchased is a good deal or it is overpriced.
How to Calculate Cap Rate
The cap rate is calculated by taking the net operating income of the property in question and dividing it by the market value of the property. The resulting cap rate value is then applied to the property an investor wants to purchase in order to obtain the current market value based on its annual income.
The formula for calculating the cap rate is given as follows:
Net Operating Income is the annual income expected to be generated by the property. It is obtained by taking the expenses incurred in the regular upkeep of the property and deducting them from the annual expected income. The expenses should include items such as property taxes, utilities, insurance costs, homeowner association fees, etc. The value should exclude the mortgage principal and interest payments.
Current Market Value represents the amount that a property can be sold in the current marketplace. The value is obtained by getting the recent sales price of similar properties in the area.
How Investors Use the Cap Rate
Investors can use the cap rate in the following two main ways:
1. When Buying
One of the applications of the cap rate is when evaluating potential investments to buy, and the tool can be a good indicator of the return you can expect on an investment. Using the cap rate on a number of potential investments can help analyze how the investments perform, and which one fits your investment goals. With the cap rate, you can compare properties according to a specific percentage, rather than make a decision based on the fluctuating market rents and property prices.
For example, assume that an investor is considering acquiring one of three listed properties. An investor can first obtain the net operating incomes for all three properties in order to calculate their cap rates.
One should also consider the recurring expenses of the properties and their periodic rents, to see if there are opportunities for reducing the expenses or increasing the rents. It can be achieved when the recurring expenses are too high per square feet of space, or the periodic rents are below the market rates vis-à-vis what other comparable properties charge.
For example, assume Property A, listed for $475,000, generates a net operating income of $40,000. Assuming that the average cap rate for comparable properties is 9.1%, we can attempt to find out whether the asking price is justified for this property.
9.1% = $40,000 / X
X = 40,000 / 9.1%
X = $439,560
A cap rate of 9.1% gives Property A a market value of $439,560. It means that the listed price exceeds the current market value by $35,440. A $475,000 market value would be justified if the property’s net operating income was $43,225 ($475,000 x 9.1%).
2. When Selling
An investor can also use the cap rate to find the current market value of a property they intend to sell based on the market value of recently sold properties in the same location. The first step when calculating the market value is to find properties that are similar to the one being sold in terms of size, type, and location.
The next step is to find their listing values, as well as their net operating income. The information can be obtained from the real estate website where such properties are listed or by contacting the real estate agents that sold the properties. The investor can then use the net operating incomes and market values of each of the comparable properties to get the average cap rate.
Assuming that the cap rate is 9.1%, as in our previous example, we can use it to get the current market value of the property to be sold, where the net operating income is known. If the net operating income of the property is $38,000, we can obtain the market value as follows:
9.1% = $38,000 / X
X = $38,000 / 9.1%
X = $417,582
Therefore, the current value of the property, based on the prevailing market rates, is $417,582. The seller can use the figure to set the asking price for the property, which will be the listing price indicated on real estate listing websites.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
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