CAP Rate

The Capitalization or Cap Rate is utilized by many investors to determine the value of a property and to measure the income potential of one property against another. The system requires a formula where two of the three factors are known. Assume the following; Income = $20,000, Cap Rate = 10% and Value = $200,000. The formulas are:

Net operating income divided by Cap rate = Value

($20,000 / 10% = $200,000)

Net operating income divided by Value = Cap rate

($20,000 / $200,000 = 10%)

Value multiplied by the Cap rate = Income

($200,000 x 10% = $20,000)

To determine the net operating income, first determine the market rent for a property at 100% occupancy. To this figure add other income (vending machines or pay telephone). From this number take away the average vacancy rate and any collection losses you anticipate—most investors utilize a market average. You have now determined the Effective Gross Income before expenses. From this figure, take away all operating costs (property taxes, heat, insurance, maintenance, utilities (electric, water, oil or gas), repairs, decorating, repair and replacement of equipment, legal and accounting, and management expenses). The figure that remains is your Annual Net Operating Income. If you are looking for a 10% annual return on our investment you simply divide the Net Operating Income by 10% and this gives you the properties value utilizing the Income Approach. Note: there is no mention of financing. The cap rate would be different for each investor if financing was included. The down payment, the interest rate, and the term of the mortgage would change the Cap Rate for each investor. To utilize the Cap Rate effectively a Realtor^® must assume that there will not be a mortgage. The Cap Rate is an equal starting point for each and every potential investor.