In the land of real estate investing you’ll begin to hear a popular term when analyzing income producing property. Capitalization Rates, better known as Cap Rates. Cap rates are a way in determining the rate of return on an investment property.
How to Calculate Cap Rates
In order to calculate cap rates you’ll need two other variables which are:
- Net Operating Income (NOI) of the property
- The Property Price / Value
Using these variables coupled with the cap rate you’ll find this common way of calculating for cap rates.
Cap rate = NOI / Price of Property
NOI / Cap Rate = Price of Property
Let’s Use an Example
Lets say you’ve found an apartment building that is selling for $200,000. How do you know if it’s a good investment and what will the rate of return be on your dollar? Well it all depends on the net operating income the property produces. For our example, let’s say the NOI equals $20,000. **Remember that NOI is after tax income.
20,000 / 200,000 = 10% cap rate
Now that we know the cap rate of the subject property, how do we know if it’s a good rate of return? Much like the comparable sales approach to valuing property you can go ahead and look at what other similar properties have sold for and what their cap rates were as well. You might have to do some digging and even call the previous Realtor up to get the NOI to run the numbers.
The rate of return should only matter to you, not what the comparables are selling for. If cap rates in your area are about 6% and you’re not okay with that, you can always negotiate with sellers to lower their price as this will naturally increase the cap rate. You can also increase the net operating income of the property by raising rents (if applicable of course) thus increasing the cap rate of the property as well.
Cap rates are directly correlated with interest rates so as rates go up or down so do cap rates. Also you should realize that each property type, whether it’s apartments, office, or industrial often have different cap rates due to market fluctuations or differences in risk associated with these property types. Calculating the capitalization rate of a property is a necessary step in properly analyzing any investment property prior to purchase. Learn it and use it as one of your tools for analyzing income producing property.
Other Useful Information for Cap Rates
One of my favorite sites for cap rate information is Net Gain’s Cap Rate Recommendations Guide which provides recommended cap rates based off the current market.