Learn to Calculate Property Value with Capitalization Rate
As a real estate agent or broker working with investor clients, you'll need to understand income property valuation methods. One used frequently uses property income and the capitalization rate to determine the current value of the property for purchase consideration. This is a good article for investors as well. If you're just starting out, understanding cap rate is important to your future business growth.
If you're a real estate investor, the first thing you want to do if you're considering buying a property is to determine not only its market value to purchase, but also its operating income and costs to determine if it meets your cash flow and profitability goals. The NOI, Net Operating Income, of a property simply defined is rents minus expenses. Here's how it is calculated.
Time Required: 5 minutes
- Determine the net operating income of the subject property the client is considering purchasing. If it's an apartment complex, determine the net rental income after expenses.
Example: A six unit apartment project yielding $30,000 net profit from rentals.
- From recent comparable sold properties, determine the capitalization rate.
- Divide the net operating income by the capitalization rate to get the current property value result.
Example: Assume a capitalization rate of 11%.
$30,000 / .11 = $272,727 current value of the property.
This is not the only method for calculating income property values. It's only one tool in the box. The value returned can be modified by using other tools and calculations. Check out our spreadsheet solution here.
What You Need:
Real estate investors use a variety of mathematical tools to analyze the performance of their investment properties.
The various valuation and financial performance calculations investors and real estate professionals use in their daily routine all have some value. However, some are much more useful than others, and the article at the link will help you to bring the best and most useful for your purposes to the top of the pile.
There are books full of complicated calculations used to value real estate and to determine the performance of real estate investments and rental property ownership and operations. Most investors only use a half dozen or so of these calculations regularly for residential property investment. Some apply to wholesaling, fix & flip and rental investing. Others are most useful to the rental investor in determining the long-term performance of their portfolios.
There is another whole level of math involved in commercial property investment. There are also some very specialized calculations used by lenders to determine whether or not to finance a purchase or project. It's good to know about them generally, as many very successful residential investors evolve into multi-family and commercial property investing.
Choosing which valuation and profit calculations to use depends on your goals and the property type. If you're an investor buying single family rental properties, you'll use some calcs, but probably not be that interested in cap rate and other multi-family oriented calculations.
The beginning of a successful rental property investment strategy is an accurate estimate of rental yield for the prospective property. When you own rental properties, the net rental yield tells you just how well your investment is doing with not only market factors and rent included, but also your costs, including management and maintenance.
Those who invest in real estate via income-producing properties need to have a method to determine the value of a property they're considering buying. Cap rates are widely used in commercial and multi-family property valuation and profitability studies.
Cap rates can be used to determine a good selling price for a property, or from the other side, the value of a listed property versus the asking price.
As a real estate professional serving investment clients, you need to be very familiar with all the methods of valuation of income properties. If you do all of your own rental property maintenance and management, you may not have any costs involved except materials, if you don't value your labor. However, it's far more likely that you have multiple costs involved, and your net operating income is the number you get after expense deductions.