Capitalization rate (or cap rate, its more friendly name) is a rate of return used in real estate investing to determine the present value (price) of a real estate investment based upon its future benefits (net operating income).

Although cap rate alone does not provide 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, it 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 Cap Rate is used for Real Estate Investing

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. You can compute a property’s cap rate. When you want to know the cap rate for, say, a recently sold property, you would use that property’s net operating income and sale price to determine the cap rate it sold for.
2. You can transpose the formula and compute a property’s estimated value. In preparation for a listing presentation, for instance, you can use the net operating income you estimate for that property and the cap rate for a similar, recently sold property to suggest a price.
3. You can transpose the formula again and compute a property’s net operating income. In cases where you are given a specified price and cap rate you can determine what the net operating income should be.

Here are the formulas:

1. Cap rate equals net operating income divided by property value
2. Property value equals net operating income divided by cap rate
3. Net operating income equals property value times cap rate

Understanding the Role of Net Operating Income

Net operating income is one of the most important calculations you will make concerning any real estate investment and the key to the cap rate formulations.

Therefore, it is 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 is a property’s gross operating income less the sum of all operating expenses. Why is it important? Net operating income represents the amount of money available to make the mortgage payment.

In other words, because cap rate measures the ratio between the money available for loan payment and sale price—essentially revealing whether a real estate investment will pay its own way–real estate investors and banks typically compute it.

To calculate net operating income correctly though, you must be clear about the operating expenses. Be sure to include everything considered an operating expense like property taxes and repairs and maintenance, and yet avoid adding what are not true operating expenses like loan payments and depreciation.

If you are not sure about correctly calculating net operating income, befriend a real estate specialist or purchase a quality real estate investment software or real estate investor software solution that will help you do it correctly.

Conclusion

Here are a few parting words about capitalization rate you might find useful.

There is no such thing as a universal capitalization rate–it depends on individual market areas. What might make a rental income property a steal in one city or state at a 5% cap rate, might not get a second look in another.

Cap rate can provide an assessment and comparison of investment properties, but you should never rely on cap rate alone to provide a true picture of a property’s profitability or make a real estate investing decision without correctly computing all the numbers, rates of return, and cash flow scenarios.

Remember that numbers can be manipulated. When you are being told how great a buy an income property is based upon its cap rate, be sure to reconstruct your own raw data to insure that all is revealed and nothing is concealed–before you actively pursue the real estate investment further.

Finally, expect to find capitalization rate in an APOD. Quality real estate investing software solutions will calculate it here, and now that you understand what it means for real estate investing purposes, you should begin to look for it.

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