Capitalization Rate: How to Compute and Use

The capitalization rate is one of the most popular rates of return real estate agents, investors, and other analysts rely upon to help them measure the value and profitability of rental income property.

As a result, it regularly appears on rental property marketing presentations, property performance reports such as the annual property operating data (or APOD) and proforma income statements, not to mention on the tongues of most active real estate investing participants. In fact, you would only have to spend one day working with investment real estate to see or hear the word "capitalization rate" or "cap rate" (the more common vernacular) popping up somewhere.

It seemed needful therefore to dig in and explain the return for those of you who are less familiar with investment real estate. So in this article we'll take a look at cap rate, including its meaning, popularity, and the two primary ways (with formulas) analysts use it to benefit their real estate analysis.

Capitalization rate is technically defined as "the rate at which you discount future income to determine its present value".

In layman's terms, however, and more meaningful for our purpose, let's simply regard cap rate as the ratio (expressed as a percentage) between a property's estimated value and its net operating income (NOI). Think of it this way: It expresses what percent of a property's value is attributable to net operating income. For instance, a value of $500,000 and NOI of $50,000 computes a 10% caprate and is consistent with the fact that the NOI is 10% of the value.

Fair enough. Now let me show you two of the ways you can use capitalization rates to benefit your investing activity and objectives.

1. Property Comparison

Because it's easy to compute, cap rate provides a quick way to conduct "rule-of-thumb" measurements of an asset's financial performance and therein facilitates ones ability to make rapid market comparisons between similar-type income producing properties at almost "one glance".

Formulation:
CR = Net Operating Income / Property Value

Example:
A multifamily apartment building producing an annual net operating income of $50,000 and listed for $500,000 would have a capitalization rate of 10.0%.

Application:
Let's say that one of your customers has expressed an interest in making a real estate investment if you can locate a rental income property that has a cap rate of 10.0% or more. What's your customer "really" requesting? That he or she wants you to locate an income-producing property that produces a net operating income equal to or greater than ten percent of its asking sale price.

What do you do in response? You examine the inventory of apartments for sale in your target area and calculate the caprate for each to determine which may or may not be a viable investment candidate.

2. Property Valuation

If you know what an appropriate cap rate for some particular type of rental income property is in your area, then you can transpose the formula to calculate a reasonable estimate of value. And this is beneficial because it ignores the seller's asking price for the property and instead determines what it should be worth based upon its net operating income and the prevailing market rate.

Formulation:
Value = Net Operating Income / Capitalization Rate

Example:
Say you want to establish the fair market value for a commercial office building that generates an annual NOI of $90,000. Based upon your comparable market analysis for similar-type buildings that recently sold in the area, you conclude that the prevailing cap rate is 10.0%. You would derive an estimated market value of $900,000.

Again, a highly simplistic example that purposely ignores other relevant considerations, but hopefully you get the idea.

Rule of Thumb

Bear in mind that rental income and operating expenses both derive the net operating income, and their numbers might be skewed. After all, it's not unusual for some sellers and agents to inflate rents and deflate expenses for marketing purposes. Therefore, whereas you might want to also explore buildings denoting a lower cap rate than your primary objective, it's also smart to refrain from becoming over-zealous when it appears to exceed your objective.

The bottom line is for you to always dig deeper into the numbers regardless, and never rely on capitalization rate apart from other criteria to make a prudent real estate investment decision.