Capitalization Rate

Appraisers use the Income Approach, Cost Replacement and Market Comparison methods to estimate the value of property. The Income Approach utilizes the theory of Capitalization.

The defenition of Capitalization Rate or Cap Rate is a ratio used to estimate the value of income-producing properties. The cap rate is equal to the net operating income divided by the sales price or value of a property. Cap rate is expressed as a percentage or decimal. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties.

A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. It provides a more reliable estimate of value than a market Gross Rent Multiplier (GRM) because the cap rate calculation uses more of a property's financial detail. The GRM calculation only considers a property's selling price and gross rents. The Cap Rate calculation incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value. Investors expect a larger return when investing in high risk income properties.

An appraiser or lender in your area can give you the local cap rate. If you are able to obtain a market cap rate from an appraiser or lender for the type of property you are evaluating, check to see if the cap rate value was determined with recent sales of comparable properties or if it was constructed. When adequate financial data is unavailable, appraisers may construct a cap rate through analysis of its component parts thus reducing the credibility of the results. Cap rates which are determined by evaluating the recent actions of buyers and sellers in a particular market place will usually produce better market value estimate for a property.

If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.

If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.

Cap Rate = NOI/VALUE      Estimated Value = NOI/Cap Rate 

Example 1:   A property has a NOI of $100,000 and the asking price 
    is $1,000,000. Cap Rate = $100,000/$1,000,000 X 100 = 10

    Example 2:  A property has a NOI of $100,000 and Cap Rates in the 
    area for this type of property average about 10%.       

             Estimated Market Value = $100000/.10 = $1,000,000

Net operating income is determined by subtracting vacancy amount and operating expenses from a property's gross income. Operating expenses include the following items: advertising, insurance, maintenance, property taxes, property management, repairs, supplies, utilities, etc. Operating expenses do not include the following items; Improvements such as a new roof, mortgage payments, income and capital gains taxes, loan origination fees, etc.

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Determine the Real Estate Financial Statistics for a Property

Before you buy an investment property it is critical that you create your own projection of the property's profitability. Real-Estate-Proforma.com has a quick-proforma with which you can calculate real estate financial statistics such as Internal Rate of Return, Capitalization Rate, Cash-on-Cash, Debt Multiplier, Loan-to -Value Ratio, Debt Coverage Ratio, and Mortgage Payments. You can use this JavaScript proforma to project the profitability of a real estate project. By becoming a member you will receive access to a number of Excel real estate proformas. membership | services

If you are analyzing another person's proforma, or you are examining a prospectus for a real estate deal, it is very important that you read the document carefully and determine how the values of the financial statistics above are being calculated. For instance, values such as the Cap Rate may be determined from overly optimistic projections of the future rental income of a property.

You can "reverse engineer" the financial projections you receive from a prospectus and/or request the Excel (or other type of) spreadsheet a developer used to create their proforma. A very useful Excel or Visual Basic macro used to check Excel formulas is available in the spreadsheet below for download. Download Mortgage Formula Excel Spreadsheet

The due-diligence you do on a potential investment may uncover a number of potential problems with a real estate deal and we suggest you research each real estate investment very carefully. There are a variety of real estate financial consultants who can help with this, but if you are like many Real-Estate-Proforma.com members, you can or are learning to do your own due-diligence.

We hope you become a more successful real estate investor by using this site! membership | services