It goes without saying that you have to determine the value of an income-producing property if you're considering buying it for purposes of investment. Failing to do so would be like flying blind, a sure way to risk and potentially lose your capital.
The challenge of valuing such property isn't as difficult as it might sound. In fact, calculating the capitalization rate for real estate is easy and should take you no more than five minutes or so.
It begins with an understanding of exactly what the cap rate is.
What Is the Capitalization Rate?
The cap rate is the rate of return you can expect on your investment based on how much income you believe the property will generate for you. It is, of course, a very important factor. You're not going to invest with the intention of losing money.
This is a great way to make comparisons of similar properties because all expenses are taken into account. When two properties seem pretty much alike but one costs more, it could be because it's generating more income or because it has lower expenses.
How to Calculate Cap Rate
You can calculate the capitalization rate using the net operating incomes and recent sales prices of comparable properties. The capitalization rate is determined and then applied to the property you're considering purchasing to determine its current market value based on income.
First, get the recent sales price of a similar income property. Let's use the example of a six-unit apartment project that sold for $300,000.
Now determine the net operating income for that apartment project or the net rentals realized by the owners. Subtract all operating expenses except the mortgage. This calculation values the property as if you had paid cash for it. Say the rental income after all those expenses you've deducted is $24,000. Now divide that net operating income by the sales price to arrive at the cap rate: $24,000 in expenses divided by the $300,000 sales price gives you a capitalization rate of .08 or 8 percent.
How to Use the Cap Rate
An investor can use the cap rate in two ways. He might want to value a property he intends to sell based on market cap rates for other recently sold comparable properties, or he might want to determine whether the asking price of a property is reasonable if he's considering purchasing it.
When You're Selling
Let's say you own a small apartment project and want to sell it. You gather information on recently sold properties in the area that are similar to yours. They could have more or fewer units, but you try to find properties that are 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 net operating incomes. Sometimes this information is published in the listing as a selling point, but often it's not, particularly when the net operating income isn't favorable. You can get this type of information from a commercial real estate agent, however, especially if you'll be listing the property for sale with her.
So you arrive at three property cap rates averaging 9.2 percent. Your property's net operating income is $31,000. Now all you have to do is divide the net operating income by the cap rate: $31,000 divided by .092 comes out to $226,957. There's the value of your property.
You can base the price you want to ask for the property on this figure and put it on the market.
When You're Considering Buying
You'll work with listed properties when you're comparing properties for a purchase decision. This makes it even easier to get their net operating incomes and to calculate the cap rate for each. You can then compare them to see which would make the best purchase.
But check out their expenses and rents anyway, because one might rise to the top if you can spot opportunities to reduce expenses or increase rents. You might find that expenses are abnormally high for a property's type and size, or you might discover that the rents being charged are below market rates for comparable properties. Either of these situations would increase the cap rate, making it a better potential property if they're corrected.
Let's say that you have your eye on a specific small apartment project that's listed for $495,000. Is it worth that in the current market or is it overpriced? Again, get some comparable properties and an average sold cap rate. We'll use our 9.2 percent rate again as an example.
If the net operating income of this property is $39,500, is it worth the asking price? No, because dividing that income by the cap rate gives you a value of $429,348. An asking price of $495,000 is a bit over the mark.
What net operating income would you need to get that list price for a value? Switch around the formula and multiply the asking price by the cap rate. Multiply $495,000 by 9.2 percent and you come up with a required net operating income of $45,540.
Remember, there can be good reasons why a property would justify a better cap rate. It might be the location or the features and quality of the buildings and surroundings. Everything must be evaluated before you make a decision, but cap rate helps.