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What Cap Rate Means to Real Estate Investors and Their Investment Decisions

Updated on June 14, 2013

Prudent real estate investors, of course, are always smart enough to look at a number of factors in a real estate analysis pertaining to a rental property before they make an investment decision whether to buy, sell, or pass.

Fair enough.

Real estate investing is a business that (not unlike any investment) is always about the bottom line. How much profitability? What rate of return? What amount of cash flows are generated?

Again, fair enough, understood, and properly registered.

But let's suppose that you're a novice investor or real estate professional trying to cut to the chase and trying to find one factor that might reveal a rental property's ability to make money. Where do you turn?

In this article, I want to suggest cap rate. Allow me to explain why by taking you through a relatively basic explanation of what it is, how you can benefit by it, and how you can compute it.

What is Cap Rate?

Cap rate (otherwise known as capitalization rate) is the rate that the future income is discounted back to determine the present value of that income. In other words, capitalization rate enables real estate investors to measure what the value of what future gains are worth in today's dollars.

Okay, but that's the technical definition. And quite honestly I have never explained it that way to either my colleagues or investors that way. So let's steer away from the textbook definition and put it in terms those of us in the real world that work with rental properties can relate to.

Capitalization rate expresses the relationship between a property's value and its net operating income. That is, it expresses the relationship between a property's current market value or listing price (i.e., "present value") and the income it produces after operating expenses (i.e., "future value").

Popularity

Cap rate is a popular rate of return associated with real estate investing for at least several of the following reasons.

First, because it's fairly easy to compute. If you're evaluating a rental property, for example, you can determine its cap rate simply by dividing its net operating income by its value (i.e., selling price).

Secondly, because the rate involves the property's net operating income, it provides a good measurement of the investment property's performance because it accounts for operating expenses.

Thirdly, because it's commonly used by most appraisers and real estate professionals, it makes it easier to compare whether or not the value of one particular rental property measures up to the value of similar income-producing properties in the local market.

Application

There are actually three useful ways you can use the capitalization rate method in a real estate analysis.

1. Arrive at Property Value

Say you were called by a seller asking you to suggest the fair market value of his apartment complex before you list it for sale.

In this case, you deduce that the subject property generates $34,705 net operating income and based upon your recent market research you discover that other properties comparable in configuration and condition have been selling at an average cap of 7.25%.

Net Operating Income / Capitalization Rate = Value
34,705 / .0725 = $478,690

2. Compute a Cap Rate

Okay, now let’s assume that you're a real estate investor or agent who just spotted the apartment complex listing illustrated above, but it's listed at $550,000.

In this situation you'll compute its cap rate to see whether it's inline with the market average you know is 7.25% for similar apartment complexes.

Net Operating Income / Price = Capitalization Rate
34,705/ 550,000 = 6.31%

Conclusion: Since the listing property's capitalization rate is lower than the market cap rate, you conclude that the property is over-priced and move on.

3. Determine Net Operating Income

Say you just called for the marketing package on the apartment complex illustrated above but all you know is what the listing agent pitched. Namely, that the asking price is $550,000 with a 6.31% cap. In this case you want to know how much net operating income you can expect that the property produces.

Price x Cap Rate = Net Operating Income
550,000 x .0631 = $34,705

Conclusion: If the rental property does not indeed generate that net operating income, someone did the math wrong and you'll need to dig deeper to sort it out.

Rule of Thumb

To derive the most benefit from capitalization rates its important to do a little research. Foremost, be sure to have accurate information about cap rates in your local market area otherwise you won't be able to determine whether the property is providing a competitive return. Secondly, be sure that the net operating income reflects realistic rental income and operating expenses to prevent a skewed return.

About the Author

James Kobzeff is a real estate professional and owner/developer of ProAPOD Real Estate Investment Software. You can learn more about the benefits of this software by visiting our website at real estate investment software.

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