Cap Rate? What is it? How do I calculate it?

[Tasha Mckoy]

Hello BP,

I know this may seem like a dumb question, but I'm new to RE investing and want to make sure I doing things correctly.  I have my eye on a property and want to plug it in to BP's deal analyzer.  It's asking me for the Cap rate in my area. How do I determine that?

[John E.]

@Tasha Mckoy There is no such thing as a dumb question. Every "expert" was once a beginner. Heck, we all started out in diapers and couldn't feed ourselves. LOL

I honestly can't think of a better explanation than @Brandon Turner's good ol' site realestateinyourtwenties.com.

See: http://realestateinyourtwenties.com/blog/cap-rates...

A cap rate is a tool used to discover the value of an income producing investment property. They are needed because, unlike single-family homes, most multifamily and commercial buildings vary significantly from one another – making it difficult to compare apples-to-apples. For example, it is fairly easy to determine the value of a remodeled 1200 square foot three bedroom, two bathroom home by simply looking at what other similar homes have sold for recently. However, trying to find similar sales of a 24-unit apartment building with a jumbled mix of one-bedroom and two-bedroom units in a low-income area proves to be too difficult. There are simply too many variables to use comparable sales as a means to determining value. Enter the cap rate.

The Cap Rate is a formula which lets us know the relationship between value and the amount of income a property delivers. I know this sounds confusing, and I’ll try not to throw too much math at you – but if you bear with me for two more minutes you will see why this is such an important piece of knowledge. Lets look at the formula (written three different ways) for determining a cap rate:

A.) Cap Rate = NOI / Market Value.

Or

B.) Market Value = NOI / Cap Rate

Or

C.) NOI = Cap Rate x Market Value

Let me explain. The NOI is the Net Operating Income. This is a term you will hear often which simply means the annual income left over after all the bills – except the mortgage – are paid. So, if a property makes $120,000 per year in rental income, and has $50,000 per year in non-mortgage bills (utilities, taxes, insurance, vacancy rate, etc), the "NOI" for the property would be $70,000.

Remember how earlier I mentioned that houses are compared with each other to determine value? With multifamily and commercial investments, it is the cap rate that is compared. If a nice apartment complex in Seattle recently sold at a 6.5% cap rate, it is safe to assume that other nice apartment complexes in Seattle will sell around a 6.5% cap rate. Generally ranging between 5% and 12%, the cap rate changes significantly from one location to another. In general, the higher the cap rate, the higher the cashflow.

If you want to determine the average cap rate for your area, ask a seasoned real estate sales agent that specializes in commercial or multifamily properties in your town or use the above equations to determine the number for yourself. It is best to analyze a number of properties and determine their cap rates and average your results. To help make this concept clearer, lets look at a possible scenario as an example.

The Example of Farmer Fred

Farmer Fred is trying to determine the value of his 24 unit apartment building. Last year, he collected $154,500 in rents and spent $75,000 in bills (not counting his mortgage payments). Therefore, he knows that his net operating income (NOI) was $74,500 last year. To find the value of his property, Farmer Fred must first find the cap rate. To do this, he looks at another property that has recently sold:

Property X recently sold for $1,500,000. It's NOI is $100,000. Therefore, using Equation A above, (Cap Rate = NOI / Market Value) we find that $100,000/1,500,000 =.0667. Farmer Fred has now discovered that Property X sold at a 6.67% Cap Rate.

Fred analyzes four other properties and knows that this cap rate is the average for his area and his style of property, so he uses this number to determine his value. Using equation B above, Farmer Fred knows that the market value of a property = NOI/ Cap Rate. Therefore, Farmer Fred computes $74,500 / .0667 to find that his apartment complex is currently worth $1,116, 941.53.

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