How to Calculate Capitalization Rate for Real Estate

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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. By using other properties' net operating income and comparable properties recent sold prices.  The capitalization rate is determined and then applied to the property in question to determine current market value based on income.

This is a great way to make comparisons of similar properties, as all expenses are taken into account.

When two properties seem just alike and one costs more, it could be because it is generating more income or has lower expenses.

Difficulty: Easy

Time Required: 5 minutes

Here's How:

  1. Get the recent sold price of an income property, such as an apartment complex.​

    Example: Six unit apartment project sold for $300,000.

  2. For that same apartment project, determine the net operating income, or the net rentals realized by the owners.  All operating expenses are subtracted, but not the mortgage. So, this calculation values the property as if you paid cash for it.  

    Example: The rental income after expenses (net) is $24,000

  3. Divide the net operating income by the sale price to get cap rate.

    Example: $24,000 / $300,000 = .08 or 8% (The Capitalization Rate)

What You Need:

  • Calculator
  • Comparable properties sold prices and net incomes.

There are two ways in which cap rate is used by investors. One is to value a property they want to sell based on the current market cap rates for recently sold comparable properties.

The other is to determine if the asking price of a property is reasonable when considering a purchase.  

Selling — Need to Know How to Price

You own a small apartment project and want to sell it. You gather recently sold properties in the area that are similar to yours. They could have more or fewer units, but you try to find properties as similar as possible to the one you want to sell.

You find three properties that have sold within the previous three or four months. The tricky part is to be able to find their NOI, Net Operating Income. Sometimes it's published in the listing, and other times it isn't. But, you can get this type of information from a commercial real estate agent, especially when you'll be listing for sale with one.

You get three property cap rates, and they average 9.2%. Your property's NOI, Net Operating Income, is $31,000. Now all you do is divide the NOI by the cap rate:

$31,000 / .092 = $336,957 Value of your property.

Now you can make a decision as to the price you want to ask for the property and put it on the market.

Considering Buying a Property or Comparing Properties for a Purchase

In comparing properties for a purchase decision, you are working with listed properties, so you can get the NOI and calculate the cap rate for each. You can then compare them to see which would make the best purchase. However, checking out their expenses and rents is smart, as one may rise to the top if you see opportunities to reduce expenses or increase rents.

On that topic, some managers are really sloppy or lazy, though not often.  However, if you are checking out a property with a comparable cap rate, you may find that expenses are abnormally high for the property type and size.

 Or, you may find that rents being charged are below market rates for comparable properties.  Either of those situations, if corrected, would increase the cap rate, making it a better property.

 Buying - Need to Know What a Property is Worth

We're on the other side of the transaction now.  We have our eye on a specific small apartment project, and it is listed for sale for $495,000.  The question is, is it worth that in the current market or is it over-priced?

We again get some comparable properties and an average sold cap rate.  Let's use our 9,2% again.  If the NOI of this property is $39,500, is it worth the asking price?

 NO, as doing our calculation of dividing that income by the cap rate, we get $429,348 for a value.  So, $495,000 is a bit over the mark.  

What NOI would we need to get that list price for a value?  We just switch around our formula and multiply the asking price by the cap rate.

$495,000 X .092 = $45,540 required net operating income.  Let's check that:

$45,540 / .092 = $495,000.

Don't think that this is set in stone though.  There can be good reasons for a property justifying a better cap rate.  Perhaps it's the location, or maybe it's the features and quality of the buildings and surroundings.  Everything must be evaluated for decisions, but cap rate helps.