Tip of the week: What is a Cap Rates ? and How to use it !!!

What Is Cap Rate? Cap Rate Formula

Definition: Capitalization rate, commonly known as cap rate, is a rate that helps in evaluating a real estate investment. 

Cap rate = Net operating income / Current market value (Sales price) of the asset.

Description: Capitalization rate shows the potential rate of return on the real estate investment. The higher the capitalization rate, the better it is for the investor. Net operating income, one of the metrics to compute the cap ratio, is found by deducting the operating expenses from the gross operating income.

The operating expenses can be property taxes, maintenance costs, etc. Operating expenses however does not include depreciation. Capitalization rate gives the first hand indicator of the investment worthiness of the asset. However, it is not an exhaustive measure by itself. 

One of the most difficult and perplexing problems for realtors and investors is finding current Gross and Net Income Multipliers and Cap Rates. Determining the value of an income property generally involves establishing either the Gross or Net Income Multipliers, or the Cap Rate according to comparable.

• How do you know what a commercial income property is worth? 
• How do you know that you can get your desired return on your investment? 
• Is there a way to calculate the maximum you can pay for an investment and still achieve your investment goals?

This e-newsletter article will answer these questions and more about valuing income property. 

Many real estate investors determine the value of an income property by using the capitalization rate, called Cap Rate 

Most of brokers, sellers, and lenders are fond of quoting deals based on the cap rate. A broker prices a property by taking the Net Operating Income (NOI), dividing it by the sales price, and voila!--there's the cap rate.

The Capitalization Rate: 

The Cap Rate is calculated as follows: 

Cap Rate = (Net Operating Income / Market Value) x 100 

Cap Rate = (NOI / MV) x 100

Example: 

Say the property has an NOI of $125,000, and the price is $1,125,000.

 $125,000/ $1,125,000 = 11.1% cap rate

Example: Net Operating Income (NOI): $239,430 

Market Value (MV): $3,420,000

Cap Rate = (239,430 / $3,420,000) x 100 Cap Rate = 7% 

The Cap Rate of 7% represents the annual return before mortgage payments and income taxes on the total investment of $3,420,000. 

Alternatively, if the Cap Rate can be established from comparable, we can determine the likely selling price of a property. 

For example, 

if the cap rate is 7.5 % based on comparable, and the Net Operating Income (NOI) for the building is $105,000 , 

the potential selling price can be calculated as follows: 

MV = (NOI / Cap Rate) x 100 

MV = (105,000 / 7.5) x 100 

MV = $ 1,400,000 

The Net Income Multiplier (NIM)

The Net Income Multiplier (NIM) is the inverse of the Cap Rate NIM = 100 / Cap Rate or 

Cap Rate = 100 / NIM

As an example, if the NIM is 11, the Cap Rate is: 

Cap Rate = 100 / NIM 

Cap Rate = 100 / 11 

Cap Rate = 9.09%

But what does that number tell you? Does it tell you what your return will be if you use financing? No. 

What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, usually by trial and error, to find the cash on cash return on our actual investment using leverage (debt).

How To Use the Cap Rate

So we know the cap rate is 8% – now what? There are three major uses for the cap rate when looking at income properties. 

1. Calculate how long it takes for the investment to pay for itself. An 8% cap rate tells us that the investment will pay for itself in 11.00 years (100% / 9.09%). 
2. Use it to compare other potential investments in the area. Prices and income can vary. Using cap rate is a good way of leveling the playing field between potential investments. Which one has a better cap rate? 
3. Use it to determine what the property is worth to you. People can ask whatever they want for a property, but the cap rate can tell you what you’re comfortable paying. Once you know what a reasonable cap rate for an area is, you can use it to determine what price you’ll pay for a house. For example, if you are looking at a property with an NOI of $16,500 and you know that 8% cap rate is what you’re looking for in that area then you can modify the formula: Cost (Value) = NOI / Cap Rate = $16,500 / 0.08 = $206,250

 So you now know, even if they are asking $225,000, you are only comfortable paying about $206,000 for the property given the comparable cap rate in the area is 8%.

STAY IN TOUCH with the Real Estate EXPERT of YOUR AREA! - Ayesha Khalid

RESIDENTIAL - COMMERCIAL BUYING - SELLING - INVESTING

Regards,

AYESHA KHALID

Realtor

Multi-Award Winner

Bronze Award (2019)

HOMELIFE/MIRACLE REALTY LTD, BROKERAGE

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