Capitalization rate (or cap rate as it is more commonly called)is a rate of return at which you discount future income (net operating income) to determine its present value (price).
Although cap rate alone does not provide The Myst Condo Showflat a true picture of a property’s profitability, because it provides a quick first-glance look at a property’s ability to pay its own way, capitalization rate is one of the most popular returns used for real estate investing.
Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property typically all use cap rate in one form or the other.
HOW TO USE
In practice, you will use capitalization rate to express the relationship between a property’s value and its net operating income for the current or coming year.
As a result, you can use the cap rate formula to achieve three useful purposes.
1) Compute a property’s cap rate – When you want to know the cap rate for a recently sold property, for instance, you would use that property’s net operating income and sale price to determine the cap rate it sold for as a way to compare it against similar properties.
2) Compute a property’s estimated value – In preparation for a listing presentation, for instance, you can transpose the formula and compute a property’s estimated value and then use that value to see how it measures up to recently sold properties of similar configuration.
3) Compute a property’s net operating income – In cases where you are given a specified price and cap rate, you can transpose the formula again to determine what the property’s net operating income should be.
1) Capitalization Rate = Net Operating Income divided by Property Value
2) Property Value = Net Operating Income divided by Cap Rate
3) Net Operating Income = Property Value times Cap Rate
We want to look at three examples to drive the formulas home. But, first, it’s crucial that you understand net operating income and the role it plays in making capitalization rate such a popular real estate investing return.
Mathematically, net operating income equals the gross operating income of an income property less the sum of all its operating expenses. If your rental property produces an annual income of $30,000, for example, and its annual operating expenses are $12,000, then the net operating income produced by your rental property would be $18,000.
When a property is not financed, net operating income, by virtue of the fact that there are no mortgage payments to deduct, is the cash flow. When the property is financed, then net operating income represents the amount of money available to make the mortgage payment, which is why NOI and returns such as cap rate and debt coverage ratio (both computed using NOI) is important to lenders.