The Capitalization Rate or Cap Rate is a ratio that is used to estimate the value of income producing properties. In basic terms, the cap rate is the net operating income divided by the sales price as value of a property expressed as a percentage.The Capitalization Rate is also used as a basis to determine an income properties true value.
Cap rate's represent the projected return on your investment for one year as if the property were bought with all cash. Cap rates generally follow property types and demographic locales. Some of the lowest cap rates in the country are in CA and NY. More suburban and rural areas generally tend to have higher cap rates. The higher the cap rate the better. A cap rate of 15% would return your investment in 7 years while a cap rate at 6.5% would take 15 or more years to return the investment.
A working example of how a cap rate is calculated is as follows:
In this example, let's say the property has an Net Operating income (NOI) of $150,000, and the seller has the property priced at $1,250,000. The formula for a cap rate is the NOI divided by the sales price.
$150,000 / $1,450,000 = 10.3% cap rate
One of the hardest parts of calculating cap rates on potential property acquisitions or investments is finding suitable comparables for Income & Expenses, Net Operating Income and other financial measures. Sales prices can generally be compared accurately, but the lack of transparency in local financial information may force you to retain a local independent valuation consultant.
