How to Calculate Property Value With Capitalization Rate
Value equals net operating income divided by cap rate
Real estate agents or brokers who are working with investor clients have to understand income property valuation methods to do their jobs right. A method that combines property income and the capitalization rate to determine the current value of a property being considered for purchase is frequently used.
If you're a real estate investor and you're considering buying a property, one of the first things you'll want to do is determine not only that property's market value but also its operating income and costs.
It will tell you if it meets your cash flow and profitability goals. And if you're starting out, understanding cap rate is important to your future business growth.
Determining Property Value
First you must determine the net operating income (NOI) of the subject property that you or your client is considering. The NOI of a rental property is its rents less its expenses. If it's an apartment complex, determine the net rental income after what it costs to maintain.
This can be a bit of a challenge because ideally, you'll need the income and expenses statements from the property which only the current owner would have. But you can also estimate NOI by multiplying the sales price by the capitalization rate.
A six-unit apartment project might yield $30,000 net profit from rentals. Determine the capitalization rate from a recent, comparable, sold property. Now divide that net operating income by the capitalization rate to get the current property value result.
Let's say your comparable property sold for $250,000. You've determined that the property's NOI after deducting applicable expenses is $50,000. Divide that by the $250,000 sales price. You have a capitalization rate of .2 or 20 percent.
If you assume a capitalization rate of 20 percent. $30,000 divided by 20 percent is $150,000, which would be the current value of the property.
Keep in mind that this isn't the only method for calculating income property values. It's just one tool in the box. The various valuation and financial performance calculations that investors and real estate professionals use in their daily routines all have some value.
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 use only a half dozen or so of these calculations regularly for residential property investment. Some apply to wholesaling, some to fix-and-flip projects, and still others to rental investing. Some are more useful to the rental investor in determining the long-term performance of their portfolios.
Commercial Property Investment
A whole new level of math is involved in commercial property investment. There are 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 because 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 calculations but probably not be that interested in cap rate and other multi-family-oriented calculations.
Rental Property Investment
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 with your costs, including management and maintenance.
The Bottom Line
Those who invest in real estate via income-producing properties should have a method to determine the value of any property they're considering buying. Cap rates are widely used in commercial and multi-family property valuation and profitability studies.
They 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 should be very familiar with all the methods of valuation of income properties. If you do all your own rental property maintenance and management, you might not have any costs involved except materials if you don't value your labor. However, it's far more likely that you'll have multiple costs involved and your net operating income is the number you get after all these expense deductions.