Using Cap Rate to Compare Properties
Capitalization rate (cap rate) is commonly used in the valuation of investment and commercial real estate because it directly links a property’s value to its income, and in turn provides an easy way for real estate investors to compare similar properties in a given area. The formula is:
Net Operating Income (NOI)/Property Value = Capitalization Rate
The two components required for calculating cap rate –property value and net operating income (NOI)—are fairly straightforward, but it won’t hurt to take a closer look.
Net operating income (NOI) is mathematically the property’s gross operating income less the sum of all operating expenses. NOI does not include mortgage payment, and in fact should be thought of as the amount of money an investor would receive in a given year (before taxes and depreciation) if the property is purchased for all cash.
Property value is simply the property’s selling price.
Okay, let’s apply the formula. We’ll assume you want to use capitalization rate to compare two similar properties currently on the market (Property A and Property B).
First, collect the data. Property A is a multifamily income property priced at $500,000 that generates an annual net operating income of $50,000. Property B is a rental income property selling for $630,000 that generates an annual net operating income of $58,500.
Second, make the calculation. For Property A divide $50,000 (NOI) by $500,000 (property value); Property A’s cap rate is 10.0%. For Property B divide $58,500 (NOI) by $630,000 (property value); Property B’s cap rate is 9.29%.
Third, compare the cap rates. In all cases, higher cap rates result in a higher value and lower cap rates result in a lower value. Remember, a capitalization rate is a measure of the ratio between net income produced and the price paid to own the property. Therefore, Property A (by virtue of having the highest cap rate) offers the real estate investor a better value than Property B.
Here’s the caveat. To correctly calculate cap rate, and get an apples-to-apples comparison, you must be sure to obtain the correct income and expenses for each property. But this is often difficult to obtain. That information is not part of any public record and relies solely on what an owner is willing to disclose and, or, how accurately a broker presents that information. So until the income and expenses can be verified, keep in mind that the cap rate calculations might be flawed.
What’s the solution? Cap rate can be an excellent rule of thumb for an easy first-glance assessment and comparison of properties, but never rely on cap rate alone to provide a true picture of a property’s profitability. Always run and examine all the numbers.
